SEC to Fund Admins: No Proof, No NAV

The US Securities and Exchange Commission has just warned fund administrators they can’t take the word of a fund manager when calculating the net asset value (NAV) of an investment fund.

When explaining its recent US$561,000 fine against Gemini Fund Services, the US regulatory agency says that when assigning an NAV to a mutual fund, fund managers must verify that all of the fund’s assets actually exist by comparing the records of the fund’s holdings to the records of other service providers. If the books don’t match, don’t strike another NAV until the discrepancy is fixed.

Fund administrators can’t assume the assets of the fund are real without the necessary evidence. And they can’t offer fund advisors much leeway in producing the necessary paperwork to prove a fund’s assets exist. GL Beyond Income Fund’s administrator Gemini did both. As a result, it was striking inflated NAVs for more than a year, because the total included about US$15 million in assets that turned out to be “fake.” All the while, Gemini knew that those assets were not booked on the records of the custodian bank.

Gemini, located in Hauppauge, New York and Omaha, Nebraska, served as GL Beyond Income Fund’s administrator, accountant and transfer agent from January 2012 until December 2014, when the fund’s portfolio manager Daniel Thibeault was arrested for securities fraud. GL Beyond Income Fund was managed by GL Capital Partners, an SEC registered investment adviser for which Thibeault was managing director.

In January 2016 the SEC ordered Thibeault to pay investors restitution. In June 2016, Thibeault was separately sentenced in a Massachussetts criminal court to nine years in prison after he was found guilty of hindering an SEC investigation and defrauding investors by making 40 fictitious loans to third-party borrowers. He had falsely reported those fake loans as assets of GL Beyond Income Fund. Thibeault, who had diverted the funds to other businesses, was ordered to pay investors of the now closed GL Beyond Income Fund about US$15.3 million in disgorgement.

What Went Wrong

The SEC says that Gemini couldn’t reconcile the fund’s records with that of GL Beyond Income Fund’s custodian from February 2013 to December 2014. Gemini should have immediately investigated the problem with Thibeault, notified investors and contacted the fund’s board of directors. What did Gemini do instead? It continued to strike an inflated NAV and report the daily NAV to Nasdaq. The SEC never identifies GL Beyond Income Fund’s custodian.

Ultimately, says the SEC, when Thibeault did produce the loan documentation in late January 2014 to prove the 2013 loans on the fund’s records were legit, the paperwork was fraudulent. The custodian bank temporarily booked all of the loans as assets on its books, but between February 2014 and December 2014, the bank changed its mind and decided to include only four of the loans on its books. Still Gemini continued to calculate an inflated NAV based on all of loans until GL Beyond Income Fund was finally dissolved in late 2014 at the time of Thibeault’s arrest.

What does Gemini have to say? In a statement to FinOps Report, the fund administrator with over US$36 billion in assets under administration, suggests it had no obligation to verify GL Beyond Income Fund’s assets were legit. That was someone else’s problem. “Gemini’s duties involved recording the purchases and sales of the fund, as well as tracking cash inflows and outflows with the custodian,” says Gemini. “Many other independent third-party professionals were involved in servicing the fund, including those specifically responsible for verifying the existence of the fund’s assets.”

Even the auditors for the GL Beyond Income Fund who worked for the Philadelphia firm of BBD LLC didn’t do their jobs right, according to the SEC. In April 2017, the US regulatory agency noted that neither audit engagement partner William Joseph Kouser nor audit manager Ryan James Dougherty had any experience auditing investment funds specializing in consumer loans. Still they were penalized for not following the correct procedures when completing GL Beyond Income Fund’s fiscal 2013 and fiscal 2014 audits. The SEC ruled that Kouser cannot serve as an auditor for any funds whose advisers are registered with the SEC for three years while audit manager Ryan James Dougherty cannot do so for two years. At the time of its action against Kouser and Dougherty, the SEC said that Kouser still worked at BBD, but not as an engagement partner for audits of investment funds. Dougherty had left the firm.

Gemini’s explanation for its misvaluation of the GL Beyond Income Fund’s loans might sound ingenuous, but it is legally valid, according to Todd Cipperman, principal at Cipperman Compliance Services, a regulatory compliance consultancy in Wayne, PA.”A fund administrator’s responsibilities depend on the terms of the contract,” he says. “However, hindsight is always 20-20 and Gemini probably wishes it had been more cautious and not taken the word of the adviser, particularly since Gemini had been previously fined by the SEC.” In 2013, Gemini paid US$50,000 for causing fund manager clients to violate the recordkeeping and reporting rules of the Investment Company Act of 1940.

In the case involving GL Beyond Income Fund, Gemini wasn’t fined for making an honest mistake and misvaluing assets. It was fined for violating the antifraud provisions of the Investment Advisers Act of 1940.”The SEC thinks that Gemini is also guilty of causing its client to commit fraud, although it is unclear whether Gemini had the requisite intent given that it may not have known of its client’s wrongdoing,” says Cipperman. The Investment Advisers Act prohibits fund advisers — managers — from defrauding investors through either misleading statements or transactions.

The SEC’s settlement against Gemini wouldn’t be the first time the regulatory agency has fined a fund administrator for ignoring red flags about a client and that fell afoul of securities laws. For example, in 2016, the SEC fined Apex Fund Services US$352,449 for allowing two fund manager clients to violate the Investment Advisers Act of 1940 by committing fraud. The clients produced false investor and financial statements.

What makes the GL Beyond Income Fund case against Gemini unique is that the SEC appears to also be suggesting a code of best practice for fund administrators, when it comes to recordkeeping discrepancies in striking NAVs. That is, the procedures to follow when the fund’s version of its holdings do not match those of a third party, namely the custodian bank.

Non-exchange traded instruments are far more susceptible to criminal activity than exchange-traded ones,'”Gemini was servicing a fund with loan assets and it is not that difficult for a fund manager to create fraudulent documentation, while keeping the fund administrator waiting for the paperwork,” says David Mahaffey, co-leader of the investment management group at the law firm of Sullivan & Worcester in Washington DC. “By contrast, ownership of exchange-traded products can more easily be verified by checking the records at the Depository Trust Company, the US central depository.” DTC will have recorded the assets in the name of a bank or broker-dealer intermediary.”

The SEC isn’t blaming Gemini for missing the fact that Thibeault’s paperwork was fake. However, it is faulting Gemini for not forcing Thibeault to produce the documentation immediately when Gemini’s recordkeeping discrepancy with the books of the custodian first surfaced. “The SEC raised concerns that Gemini waited too long for the loan documentation to be produced while taking no corrective action and still calculating the NAV,” says Kelley Howes, an attorney in the investment management practice of Morrison & Foerster in Denver.

Fund administrators have a responsibility to compare the assets it believes the fund holds with the the books of a custodian bank or prime broker, asserts Iyer Shankar, chief executive of Viteos Fund Services, a Somerset, New Jersey firm specializing in shadow accounting for hedge fund managers. If they don’t, it’s time to act.  “It is unclear why Gemini did not notify the board of the fund or its investors of any concerns during all the time the custodian bank did not include the assets in question on its books,” he says.

Shankar recalls that when Viteos finally received documentation from a fund manager about assets on its books after repeated requests it decided to promptly end the relationship. Viteos also notified the fund’s board and investors about  why it had terminated the service contract. “We were uncomfortable doing business with the fund manager even though we had no proof of wrongdoing,” he says. Howes says that it is possible that had Gemini insisted it would no longer strike an NAV without the proper loan documentation or had Gemini immediately terminated its relationship with the GL Beyond Income Fund, it would not have been fined by the SEC.

Proper Protocol

Saleemah Ahamed, a managing director at Adherence LLC, a New York consultancy specializing in regulatory compliance, recommends that fund administrators set up airtight procedures for when board of directors, regulators and even investors must be notified about problems striking an NAV. “There should be no more than a two-day period when the books of a fund administrator and custodian cannot be reconciled,” she explains. “The board of directors of the fund must then be notified and, depending on whether it can resolve the discrepancy with the fund manager, investors and regulators must also be informed.” In the case of Gemini, the regulatory agency was Nasdaq which was publishing its daily NAVs for the GL Beyond Income Fund.

Mahaffey urges that written escalation procedures specify that operations managers responsible for asset reconciliation should immediately notify their business managers of any breaks. When reconciliation takes too long to resolve, chief compliance managers must also be brought into the discussion. Ultimately, as fund compliance managers also tell FinOps, the CCO of the fund administrator might need to have a hard talk with the CCO of the fund adviser about what additional paperwork is necessary and by when. Or else. The chief executive officer of the fund administrator may ultimately decide the fund manager is not keeping as a client.

Gemini would not respond to FinOps’ questions about its policies and procedures during the time it serviced the GL Beyond Income Fund. As part of its settlement with Gemini, the SEC required the fund administrator to hire an independent consultant to review its operations. In its statement to FinOps, Gemini suggests that its previous process for striking NAVs was far from perfect. “Today, Gemini has more sophisticated asset reconciliation policies and procedures in place than it did at the time it serviced the fund, more than three years ago, including enhanced escalation procedures and dedicated reconciliation teams,” says the statement. “Gemini has also made significant system enhancements, including implementing a best-in-class fund accounting and reporting system offering detailed operational and monitoring workflow tools.”

An ounce of prevention can also go a long way to prevent fund administrators from being stuck with a potentially fraudulent fund manager. Cipperman recommends that fund administrators spend more time evaluating a client before it is signed on. Such due diligence involves verifying the background of the fund manager as well as that of every board member. “We won’t accept a client unless we have tracked down all the information about it using public databases,” says Shankar. “The same applies to board members whom we expect to be independent and not have any affiliation with the firm.”

Mahaffey questions whether all that legwork will be enough to prevent a fund administrator from potentially being caught up in a fund manager’s fraud. Media reports list Thibeault as a graduate of Harvard Business School and a former employee of Wall Street giant Goldman Sachs.

“Certainly due diligence is advisable,” says Mahaffey. “However, it is also a good idea for a fund administrator to never trust its client completely and be more vigilant about protecting itself during the course of the relationship.”