Home/SEC Charges Investment Adviser with Defrauding Clients and Prospective Clients

SEC Charges Investment Adviser with Defrauding Clients and Prospective Clients

WHAT HAPPENED?

On August 31, 2017, the SEC charged an investment adviser and its principal (collectively, the “Defendant”) with misleading clients and prospective clients about the performance track record of an investment strategy they offered.  The SEC explained that the Defendant’s violation of its fiduciary duty was a result of three separate courses of business:

  1. Ignoring red flags that the performance track record was inflated while performing inadequate due diligence;
  2. Disseminating marketing materials that contained false statements about the investment strategy and never informing clients about the prior misrepresentations once they were discovered; and
  3. Selling the investment strategy line of business to a third party in order to profit from the company’s fraudulent marketing and avoid disclosing the conflicts of interest.

INADEQUATE DUE DILIGENCE

In 2009, Defendant entered into a model manager agreement with F-Squared Investments (“F-Squared”), a third party registered investment adviser, under which F-Squared provided Defendant with trading signals for one of Defendant’s strategies.   Defendant conducted due diligence on F-Squared prior to entering into the agreement.  During the due diligence process, F-Squared provided several pieces of misleading information about the performance track record of the investment strategy.  The information stated that the investment strategy was used to manage real client assets from 2001 to 2008.  However, no assets tracked the investment strategy until late 2008.

When Defendant requested to review documents supporting these performance pieces, F-Squared either denied the request or provided documents that did not generate the claimed results.  Defendant’s failure to thoroughly analyze each document and address identified red flags highlights the inadequacy of the due diligence process.

DISTRIBUTION OF MISLEADING MARKETING

After entering into the model manager agreement, Defendant disseminated marketing pieces that included charts and related data reflecting a historical performance track record of the investment strategy between 2001 and 2008.  The information originally provided by F-Squared was not based on the performance of actual assets and was inflated due to errors in F-Squared’s method of computation. Although F-Squared did not provide any documentary support for these claims, Defendant continued to distribute the marketing materials to clients and prospective clients.

In 2011, F-Squared informed Defendant that the investment strategy was not based on the performance of real assets.  Nevertheless, Defendant continued distributing the misleading materials and failed to further investigate the issue.

SALE OF BUSINESS

In 2013, Defendant sold its investment strategy business to F-Squared for $14 million, with the alleged intent to avoid potential liability for the marketing of a fraudulent track record.  Defendant never disclosed to clients that it distributed misleading marketing or the conflict of interest resulting from the sale.

Defendant’s activities were in direct violation of Section 206(1), 206(2) and 206(4) of the Advisers Act.  Accordingly, the SEC has required Defendant to disgorge their ill-gotten gains, plus pre-judgement interest, and pay a civil penalty.

WHAT DOES THIS MEAN FOR ME?

The SEC’s recent case emphasizes the importance of having a thorough compliance program that will perform adequate due diligence when evaluating agreements with third parties.  This includes the ability to identify risks, address the risks, and determine if the third party can sufficiently resolve any red flags.

Firms should ensure that they have the necessary written policies and procedures implemented to effectively review all marketing.  Firms’ compliance programs should retain the appropriate documentation to support all disseminated marketing pieces, including those provided by third parties.  Please contact Fairview if you have any questions or concerns about how this relates to your firm.

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Fairview
Founded in 2005 with the goal of developing streamlined back office solutions for investment advisers. Fairview is now servicing investment advisers, foundations and funds with over $132 billion in collective assets.