Adviser Misled Clients About Insurance Feature, Says SEC
If you tell your clients that an account has a particular bell or whistle, but then you fail to provide that bell or whistle, youíd better clear up their mistaken impression, pronto. Particularly if a portion of their fee is ostensibly being used to pay for that account feature.
Thatís the lesson to be drawn from the SECís recent case against North Potomac, MD-based National Investment Advisors and Douglas Jimerson, the firmís president and majority owner. According to the SECís December 27 order announcing the settled proceeding, Jimerson offered clients a principal-guaranteed account, whereby clients were guaranteed the return of their principal regardless of the accountís performance. One percent of their fee paid to NIA would be used to purchase account insurance. Clients were required to keep their money invested in the account for at least five years.
But NIA ran into a little problem. In September 2001, the insurer that NIA had used to provide the safety-net underlying its principal guarantee decided to stop insuring new accounts.
Jimerson shopped around for a replacement policy, but he couldnít find one. So he decided to do it himself by setting up his own off-shore captive insurance company. While in the process of setting up the captive insurer, he began offering a new account type, this time requiring a seven-year lockup. He told clients that his firm had purchased "Registered Investment Advisors Professional Liability Insurance," which insured that the firmís management of the account "will not result in a loss of principal for our clientsí accounts" when continuously managed for a seven-year period.
According to the SEC, however, the firm didnít actually have the insurance in place. Instead, NIA kept the portion of the fee that was supposed to pay for the insurance feature as an "undisclosed addition to its management fee."
After a few months, Jimerson realized that he was not going to obtain full funding for his captive insurance company. He resumed his search for a replacement insurance policy. Eventually, Jimerson obtained errors and omissions insurance, apparently thinking that some insurance was better than none. E&O insurance, of course, does not protect clients from loss of principal caused by market events.
But thatís apparently how Jimerson marketed his new accounts, according to the SEC.
Eventually, the E&O carrier got wind of Jimersonís marketing (among other things, he touted the E&O insurance coverage on his website) and asked him to stop referring to the E&O coverage as a financial guarantee. "[W]e believe the description provided by NIA suggesting and/or implying that [the insurance company] is providing some form of financial guarantee insurance coverage is incorrect and perhaps fraudulent," said the insurer.
When Jimerson persisted in marketing the E&O policy as a financial guarantee, the E&O carrier unilaterally voided the policy and returned $105,060 in premiums. But instead of returning that amount to his clients, NIA allegedly pocketed it and turned around and purchased a $38,000 E&O policy from another carrier. Jimerson similarly claimed that the new E&O policy operated as a financial guarantee that protected clients against loss of principal.
Enter the SEC. In addition to out-and-out fraud, the SEC asserted that NIA and/or Jimerson ran afoul of a variety of provisions under the Advisers Act:
Rule 206(4)-1(a)(5), which prohibits advisers from distributing false advertisements. The SEC alleged that NIA and Jimerson falsely misrepresented to clients that one of the firmís programs had an insurance policy, when it did not. The SEC also alleged that when they subsequently obtained E&O insurance policies, they falsely told clients that those policies would protect against loss of principal.
Rule 206(4)-4(a)(1), which requires certain advisers, including those that have discretionary authority or custody over client assets, to disclose all material facts about their financial condition that are reasonably likely to impair the adviserís ability to meet contractual commitments to clients. The SEC alleged that NIA and Jimerson failed to tell clients that the firmís liabilities exceeded its assets. If any client submitted a claim to recoup their losses, said the SEC, the firm would not have had enough capital to fulfill its obligation to cover the claim.
Rule 204-1(a), which requires firms to amend their Form ADV at least annually, within 90 days of the end of their fiscal year, or more frequently, if required by Form ADV instructions. (SEC-registered advisers must "promptly" amend their Form ADV before their annual amendment under certain circumstances. See "Form ADV: What Has to Be Updated, When?" in the February 20, 2006 issue of IM Insight.)
Rule 204-2(c)(1), which requires advisers that provide "investment supervisory or management services" to make and keep records showing the specific securities purchased and sold for each client, along with the date, amount, and price of each such purchase and sale. NIA allegedly failed to maintain these records.
Section 207, which basically makes it unlawful to lie in oneís Form ADV or any other Advisers Act filing made with the SEC. The SEC alleged that in two ADV filings, NIA stated that it had $165 million in assets under management, and that all of its assets under management were non-discretionary. According to the SEC, NIAís actual AUM was under $100 million, and "a large portion" of those assets were discretionary.
To settle the SECís proceeding against him, Jimerson agreed to be permanently barred from associating with any investment adviser and have his firmís SEC registration revoked. The SEC agreed to waive payment of over $500,000 in disgorgement and interest, given Jimersonís stated inability to pay.