ARTICLE II - INVESTMENT ADVISER ENFORCEMENT CASES

Investment Adviser Enforcement Cases

A ten (10) year review of the SEC website shows that enforcement cases brought against investment advisers is a small percentage of the number of cases brought against securities industry persons and firms, especially broker-dealers and their associated persons. Moreover the enforcement cases against Investment Advisers are driven not so much from violations of technical standards that are textually based but on hard core fraud that are not sui generis to Investment Advisers. The protypical cases involve: (a) the filing of false material information about the advisor firm and associated persons on such items as assets under management, the firm’s size and client base; false advertising in respect to past performance and other information reflecting upon the adviser’s competence; a diversion and theft of funds and securities and covering up such activities; blatant conflicts of interest; preferring one client or group of clients over others; undisclosed payments to obtain or keep clients, i.e., "buying business"; and violation of the securities laws when operating in the dual roles of investment adviser and broker-dealer.

In the Matter of Ira William Scott , the investment adviser was criminally convicted of selling unregistered securities and client theft and as a result was barred. The respondent advised his clients to invest in low risk and secure investments that would be earning healthy profits. The funds of the clients were used, however, to purchase a contingent interest in a Mexican minor league baseball team, vacant land in Mexico, and three race horses. The District Court enjoined respondents’ securities law violations.

In trying to award the SEC’s jurisdiction, the respondent argued he was not an investment adviser. The Commission addressing this argument made reference to 15 USC 80b-2(a)(1) that defined an investment adviser as "any person who for compensation engaged in the business of advising others ... as to the advisability of investing in, purchasing, or selling securities", and this is the role respondent served in respect to his clients.

The president of a registered investment adviser in In re: Christopher A. Lowry made misrepresentations in respect to how offering proceeds would be used and in fact he diverted the funds to his personal use. Accordingly he had been subject to a permanent injunction and was barred from association with any investment adviser or broker-dealer.

The respondents’ area of speciality was operating an "administrative company that would group 401(K) plans to provide lower-priced investment management, educational, and administration services to small employers offering 401 (K) plans." Respondent commingled funds raised in an offering with another corporation he formed and operated. Further, the respondent used the offering proceeds to purchase a house for himself and his fiancee.

Respondent continued to offer securities after one-third of the offering proceeds were diverted. The facts came to light in an inspection. The Commission issued an investigative subpoena and respondent in testimony claimed he borrowed the money and produced a promissory note. The loan was never documented. Section 203(e) authorizes the commission to sanction an adviser or associated person where there is a willful violation of any provision of the federal securities laws or was enjoined from engaging in conduct in connection with the purchase or sale of a security. The Commission held:

" ... [Respondent] contends that he ‘borrowed’ the money and that state law permits loans from corporations. Even if there had been a valid ‘loan’ ... [Respondent] acted fraudulently because he failed to disclose that he had ‘borrowed’ or intended to ‘borrow’ investor funds for his personal use when he offered and sold ... stock to his ... [advisory] clients. The fact that a majority of the company’s investors in the offering may have ratified ... [Respondent’s] purported ‘loan’ several months after he used the funds does not affect our authority to sanction him."

Not only was the loan not documented, but the promissory note was dated the same day as the SEC inspection. Respondent made contradictory statements about the purpose of the loan during the investigatory stage. In deciding upon sanctions, the Commission gave consideration to the Fifth Circuit’s opinion in Steadman v. SEC and noted that sanctions are appropriate even if the losses were minimal or the clients were given compensation for their losses. In imposing sanctions, the Commission noted consideration "extends beyond the consideration of particular investors to the public-at-large". Respondent argued to the Commission without him the business would collapse. This was moot because the business terminated in 1999 before the 2001 administrative proceeding. The key consideration was that the Commission felt it appropriate to "remove ... [respondent] from a position to engage in similar misconduct" and therefore respondent was barred from association with an investment adviser.
In re: The Barr Financial Group Inc. and Alfred E. Barr was a case in which the respondent, a principal of an investment adviser firm violated Section 207 by filing false material documents with the SEC in 1997 and 1998. In 1999 respondent was enjoined from violating Section 204 which requires advisers to file reports, maintain books and records, and make those records available to the staff for examination. Rule 204-2 establishes record keeping requirements. The Administrative Law Judge issued a cease and desist order from violating Sections 204 and 207. The injunction followed an examination and false filings on the ADV form as to the dollar amount under management and whether the firm had custody of funds and securities or merely provided research and general market advice, which services alone do not establish an investment management relationship. Respondent also misrepresented his background on the ADV form.

Th SEC’s Office of Compliance, Inspections and Examinations ("OCIE") examined adviser firms every five (5) years. The SEC staff was concerned about the report of assets under management going to $70,000,000 in one year. The individual respondent had been disciplined by the state of Kentucky and OCIE did a "for cause" examination. In the examination, the respondent would not provide brokerage confirmations and statements to verify the assets under management. Further, the staff offered respondent the opportunity to protect client privacy by redacting names and social security numbers. Even with that offer, respondent would not agree to the compromise.

After the SEC went to the United States District Court to enforce its subpoena duces tecum, the District Court enjoined further violations of Section 204 of the 1940 Act. Respondent produced inaccurate records which included false dates on trades and the recording of trades that did not take place. False information was also provided on the ADV Form in respect to the firm’s asset base and the individual respondent’s professional qualifications. Add to the foregoing the respondent did not cooperate with the staff in the examination process. The door was also shut tightly on respondent’s future in the securities industry because respondent was collaterally estopped from contesting the facts underlying the injunction and accordingly the severest of sanctions were appropriate.

The Commission stated:
[T]he egregiousness of the defendant’s actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant’s assurances against future violations, the defendant’s recognition of the wrongful nature of his conduct, and the likelihood that defendant’s occupation will present opportunities to future violations."
The case at hand demonstrated "serious misconduct in light of ... [the above-stated] standards." In arguing against a revocation and bar, respondents argued against the comparative seriousness of different cases, which the Commission rejected.

The Commission stated:
"Respondents also claim that a comparison of sanctions in cases involving what they assert is more serious conduct demonstrates that a bar order and registration revocation are excessive here. We have consistently held that determining appropriate sanctions depends on particular facts and circumstances and not on a comparison with action taken in other cases."
Public interest, a key consideration, is the equivalent of specific risk to the public investor and this is what determines the sanctions the Commission imposes. A likelihood of repetition and posing a continuing threat mandated severity in the case before the Commission.

In re: Marshal E. Melton and Asset Management & Research Inc. also represented a case of serious misconduct, as there was a misuse on a repeated basis of client funds that justified both a revocation and bar. Material misstatements were also made to induce investments. There was a commingling of investor funds with the funds of companies that were controlled by the adviser’s principal. There was an overstatement of funds under management and misrepresentations as to past performance. Further, there were misrepresentations that profits from the investments would cover the clients’ margin debt and interest. There was not any disclosure of the unrealized losses to assets carried on the books.

Investor funds were used to buy the principal a luxury home, and invest in companies controlled by the adviser’s principal. Investor funds were also used to repay the debts of these companies. One company was to do day trading and another covered call writing. It was represented there would be distributions from the trading profits, instead the companies were caused to pay debts not owed and fees that were not justified. Great weight was given to the prior injunction. The Commission further made an important statement in its opinion about the policy underlying anti-fraud injunctions, stating:

"... [A]n anti-fraud injunction can, in the first instance, indicate the appropriateness in the public interest of revocation of registration or a suspension or bar from participation in the securities industry."

The Commission noted there were no distinctions between injunctions after hearing and consent. The Enforcement Division in a follow-up proceeding does not have to prove the allegations of the injunctive complaint. Even consenting to the injunction without admitting or denying the allegations precludes denying the allegations in a follow-up administrative proceeding. The Commission also noted the seriousness with which it viewed violations of the anti-fraud provisions, declaring:

"... [Violation of the] anti-fraud provisions of the federal securities laws is especially serious and subject to the severest sanctions under the securities laws."

From the foregoing a question arises as to whether the above quoted language covers non-scienter fraud under Section 206(2) of the 1940 Act.

Another case of serious fraud, including the attempt to cover up, requiring bar and revocation was In re: Michael Batterman and Randall B. Batterman III. The advisers were the advisers to a foreign investment company that was not registered with the SEC. Shares were sold to American investors. There were misrepresentations and material omissions in regard to one of the individual advisers prior criminal and disciplinary history. The son knew about his father’s background. Both represented the father’s unblemished record. This false information was capped by a misappropriation of the investor funds received from the sale of investment company shares. To conceal the fraud and induce further investment, misrepresentations were also made about the investment company’s financial performance. Not only did a United States District Court issue an injunction, but the Administrative Law Judge found no evidence of mitigation or rehabilitation.

Pursuant to Section 203(e)(4), the Commission held the injunction was sufficient to warrant a bar or revocation. The Steadman factors also warranted revocation and individual bars. The Commission again noted: "(a)n anti-fraud injunction can, in the first instance, indicate the appropriateness in the public interest of revocation of registration or suspension or bar from participation in the securities industry." The violations in the case were also viewed as "on-going, not isolated, and occurred over several years."

Other brands of investment adviser fraud center around "buying business" and treating one client or group differently from more preferred clients. In re: Clarke T. Blizzard and Rudolf Abel addresses this type of conduct. There was a failure to disclose the use of client commission dollars to obtain client referrals from brokers. The respondents claimed brokers were selected based on the research provided and not the referrals. The respondents’ investment adviser firm selected the brokers unless directed otherwise by the client. It is not automatic that a broker who refers its customers to investment advisers and then receives the client’s brokerage lessens the quality of both the adviser’s and broker’s service. The Commission in respect to this non-disclosure stated:

"...[The] investment adviser ... [is] required to obtain best execution when it arranges trades for its clients. If, however, a broker-dealer provides research to ... [the] ... [investment adviser] ,,, [the investment adviser is] permitted to pay more than the lowest price available, using a practice known as ‘soft dollars’ whereby brokerage firms are paid for their research, as well as executions, through commission dollars rather than through direct cash payments. The research paid for in soft dollars may be proprietary to the broker, or it may originate with a third party vendor that the broker compensates.

An investment adviser’s arrangement to direct brokerage in exchange for benefits to the adviser creates a conflict of interest that is material and that must be disclosed."

The written trading policy was to direct client securities transactions to brokerage firms that provide competitive execution, with preference given to firms that provide research that benefits all the clients. Client referral is not to be considered. In the case before the Commission, trades were directed to the brokers who provided client referrals. This practice of "buying business" and allocating commissions based on marketing considerations that was neither disclosed nor reported was and is fraud.

The factors by which brokers are selected have to be disclosed in Part II, Item 12, Page 6 of Form ADV including products given such as research. There was no mention of client referral in respondents’ firm’s ADV. The Commission emphasized ""(s)ecurities professionals are required to be knowledgeable about, and to comply with, requirements to which they are subject" and disclosure of client referrals and the value of products if those are provided. Specifically the ADV Form requires disclosure regarding "arrangements by which the advisers provide compensation for client referrals." An omission of this information constitutes "an extreme departure from the standards of ordinary care", i.e., recklessness.

In respect to one respondent the Commission dismissed the charges as beyond the statute of limitations. Fines and forfeitures have to be sought within five (5) years from the date the claim first accrued as required by 28 USC 2462. In respect to the other respondent, he was open about the referrals and fully discussed it with senior management that had the responsibility for filing the ADV Form. Nor did he have involvement in preparing the ADV Form and accordingly the administrative charges were dismissed because there was insufficient evidence he was aider and abettor.

In respect to investment adviser fraud, it is often times difficult to determine who in the investment firm participated in the transactions and rendering of services and actually committed fraud. In respect to In re: Charles K. Seavey , material false statements were made by hedge fund advisers to fund investors that violated Sections 206(1) and (2). A manager of an investment advisor firm that operated and controlled a hedge fund was charged with the violations. The fund paid $239,000 for stock supposedly worth $750,000 and a misleading letter was sent to investors in regard to this transaction since the shares were never delivered to the fund and the fund included the value of the shares in its performance number for the year.
The manager was aware of the problem and counsel "advised ... [the manager] that he had no obligation and, in fact, no right to disclose the situation to investors or report it to criminal justice or regulatory authorities ... (h)owever ... [the manager was] warned not to make any affirmative misrepresentations to the investors." The manager tried to persuade his superiors the fund was defrauded and not only should referrals be made to prosecutors and regulators, but litigation commenced. No meaningful action was taken.

The manager also wrote a letter to investors describing a return of four (4%) percent from year to date when in fact if the shares value was excluded from the performance numbers as it should have been, there was a seventy (70%) percent loss. The Commission took the position this information was material for a reasonable investor.

The Commission’s staff also took the position the manager could not assert reliance on counsel as a defense because he did not follow the lawyer’s advice to avoid making "affirmative misrepresentations to investors." The manager defended himself that he had disclosed an "administrative problem" (albeit the problem was not specifically described) and he was identified and served as a line of communication between the fund, advisers, and investors. The Commission did not accept the argument. It held the manager’s "refusal to sign a materially misleading letter accompanied by arguments in favor of full disclosure, might have resulted in an accurate report of the fund’s performance" and prevented violations of the securities law. According to the Commission although this was an isolated occurrence for this firm, the violation was considered a serious violation. The Commission as a result affirmed a Section 203(K) Cease and Desist Order and the imposition of a second tier $10,000 monetary penalty.

Another case that illustrates the Commission’s focus on the public interest or as more clearly described, the risk to investors in the future is In re: Monetta Financial Services Inc. . The adviser to mutual funds and individual clients breached its fiduciary duties by not disclosing the allocation of IPO (Initial Public Offering) shares to the directors of the funds. The Commission regarded this non-disclosure as a potential for abuse because it could undermine the directors meeting their responsibilities to supervise the advisers handling of the funds so as to avoid inequitable IPO distributions to insiders, even though this did not occur in this case. The Commission concluded there was a violation of Section 206(2) and there was an absence of scienter.

The Commission reduced the Administrative Law Judge’s $200,000 sanction to $40,000 as it viewed the penalty as being appropriately in the first or lowest tier of the statutory framework. The Commission considered that the firm’s principal gave false testimony in respect to his reliance on counsel and he also lacked candor in statements to the OCIE examiners as to how the directors received their IPO allocations. However, it balanced this off against the fact to the violations occurred more than ten (10) years ago in an eight (8) month period and the adviser firm no longer served individual clients, making the likelihood of future violations of this nature.

What the foregoing analysis shows is that the Securities Exchange Commission primarily through its Division of Enforcement has concentrated on investment adviser fraud and rule making to enhance competency and ethical standards as well as bringing cases on distinct breaches of fiduciary duty as opposed to fraud has had significantly less attention.

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