Diversion of Investor Dollars During Fund Wind-Down Draws SEC Ire
Winding down a fund is not an opportunity to divert money to other investments Ė thatís just misappropriation of client assets, otherwise known as theft.
That lesson is†just one of several†that advisers can draw from a December 29 administrative action the SEC took against a New York-based advisory firm and three of its principals. The agency accused them of diverting $4.4 million of investment capital from two funds that were winding down to prop up an affiliated business without first disclosing the diversion to the investors. The firm and the principals also found themselves facing charges involving principal transactions and custody of client assets.
The firm, VERO Capital Management, and three of its top principals Ė its president, general counsel, and chief financial officer Ė now face a public hearing before an administrative judge to determine whether the allegations are true and whether they will face fines and a suspension from the securities industry. The president owns 42.3 percent of the firm, the general counsel 11.5 percent, and the CFO 5.4 percent.
"VERO Capital and its officers allegedly misled their investors about the fundsí investment activities and funneled money to their side project while winding down the funds," said SEC New York Regional Office director Andrew Calamari.
"When you are winding down a fund, its assets are supposed to be distributed to investors," said Mayer Brown attorney Adam Kanter. Plans to place the assets into investments not allowed by the current PPM would require the investorsí approval, he said, and, in such cases, "investors are not likely to approve another investment, but there are exceptions. Thatís up to the investor to act on, and itís not something that is done lightly."
Failures in multiple areas
Regardless of the truth behind the SECís allegations and the fiduciary issues the case raises, the agencyís action serves as an ample warning to advisers to consider the high cost that non-compliance may bring in the way of SEC attention, litigation risk and loss of credibility. Specifically, the SEC alleged that the advisory firm and its principals failed to:
Let investors know about their alleged diversion of fund assets to the affiliated company as they wound the two funds down,
Disclose to investors that they made unauthorized loans totaling $800,000 from the fundsí bank account to the affiliated company,
Provide required notice to the funds or obtain required consent for three principal transactions, and
Arrange for a surprise examination or an independent accountant audit of the funds, for which they had custody.
Letís start with VERO Capitalís two funds, which had a master-feeder relationship. Under the relationship, one fund, the feeder, invested most of its cash in notes issued by the other fund, the master, which invested in mortgage-related securities, an investment strategy that the SEC said was spelled out in the feeder fundís private placement memorandum. Both funds were owned by a Dutch company, which delegated to VERO Capital exclusive power and authority to manage the fundsí investments, according to the SEC administrative order. VERO Capital, which registered as an adviser with the SEC in 2008, marketed the feeder fund to three foreign investors that year, raising $80 million, with "the vast majority" of that amount coming from two of the investors, the agency said.
VERO Capital was allowed to purchase loans syndicated or originated by an affiliate or engage in affiliated transactions on behalf of the feeder fund, but was first required to obtain prior written consent from†the firmís investment committee Ė of which its three principals named in this action were members.
The affiliated business and first aid
The role of the affiliated business, which VERO Capital began developing in approximately 2008, was to provide large financial institutions with a platform to assist them with modeling the valuation of various pieces of their portfolio in different economic scenarios. "VERO Capital anticipated that the demand for this type of service would increase following the financial crisis in 2008 and the passage of the Dodd-Frank Act, with its requirements that large financial institutions perform Ďstress testsí on their portfolios," the SEC said.
Unfortunately, things did not go well for the affiliated business, with only a bit more than $525,000 in revenues from its inception in 2008 through October 2013, according to the administrative order.
"[The three VERO Capital principals], through VERO Capital, misappropriated $4.4 million in assets of the funds for purposes of financing [the affiliated businessí] operations," the agency charged. The alleged misappropriation, described as "bridge loans," occurred from December 2012 through October 2013, and apparently stopped at the same time as an SEC examination of the advisory firm.
"These loans were never documented, nor were any of them disclosed to the funds or their investors until well after the Division [of Enforcement] had commenced its investigation," the SEC said, adding that the three principals "did not follow the procedures for affiliated transactions set forth in the PPM. Nor were any of the bridge loans to [the affiliated business] reduced to writing." Instead, the agency said, the loans were simply recorded in the master fundís general ledger.
Principal transactions Ö and more diversion
VERO Capital purchased three notes worth $7 million between late 2010 and 2011 from an affiliate, the SEC said. The purchase was approved by the firmís investment committee, but that was not enough. "Because the funds were purchasing the notes from a VERO Capital affiliate, the transactions constituted principal transactions under Section 206(3) of the Advisers Act, which requires written notice and consent of the client before the completion of the transaction," the agency said. "Respondents, however, made no efforts to provide the required notice to the funds or obtain the required consents for the three transactions."
"Anytime you engage in principal transactions, there are a lot of bells that should be going off," Kanter said.
Specifically, in November 2010, the investment committee approved a transaction in which the feeder fund would purchase a $3 million note from a wholly owned subsidiary of VERO Capital. In February 2013, the note was in default. "VERO Capital made no effort to collect on the [note] on the fundsí behalf," the SEC said.
In December 2011, the firmís investment committee approved the purchase of two additional promissory notes, which allowed the firm to loan $4 million to two unaffiliated issuers. The firm recouped approximately $2.1 million of the principal from two notes. "Of this amount, VERO Capital returned $1.5 million to the master fund in September 2012," but "diverted the remaining approximately $600,000" to help prop up its affiliated business, the agency said.
"This is a classic example of the SEC trying to contort the Adviser Act to apply to a situation for which it was never intended," said
Stern Tannenbaum partner Aegis Frumento. Section 206(3) requires disclosure of related party transactions to the client and, "in a normal adviser/client relationship, the adviser is the adviser and the client is the investor. But in a private fund situation, the client is not the investor, it is the fund. The SEC is here trying to make the fundsí investors the Ďclientí for purposes of the statute, but that is simply not how the Advisers Act was written."
However, despite Frumentoís belief that the Commission "is wrongly reading the Advisers Act," his practical advice to any fund manager or investment manager is to "act as if the individual investors were the clients of your advisory relationship when dealing with disclosure and consent obligations."
"The Commissionís impetus is to Ďlook throughí the fund structure to the individual investors," he said. "The Commissionís thinking is that by their very nature, fund governance structures Ė especially limited partnerships and LLCs that give wide discretion to general managers and managers Ė create opportunities for unscrupulous fund managers to take advantage of the bottom-line investors even though the fund itself is dealt with properly. So, to stay out of firing range, fund managers should not rely on the existence of a fund between them and their investors when it comes to disclosure and conflicts. Pretending that you have a direct advisory relationship with your fundís investors, whether or not you legally do, would prevent a lot of these issues."
Loans for life support
It must have been difficult to let the affiliated business die its natural death. In August and September 2013, despite the diversion of investor money described above, the affiliated businessí bank account "was nearly depleted," the SEC said. So VERO Capital made two loans, one for $500,000 and†another for $300,000 from the master fundís custodial bank account, to prop up the business, according to the agency.
The advisory firmís CFO, in an email to the bank, "falsely advised the bank that VERO Capital [through an affiliate] would invest the $500,000 that he requested in a property."
Custody rule violations
VERO Capital was considered to have custody of the fundsí assets because it was authorized or permitted to withdraw money from the master fundís custodial account. As such, it was required under Advisers Act Rule 206(4)-2 to, among other things, provide notice to investors in the funds upon opening the custodial bank account, ensure that the bank was delivering quarterly account statements to the investors, and undergo an annual surprise examination by an independent public accountant (or, alternately, ensure that the funds were audited annually by an independent public accountant).
"VERO Capital did neither in 2012 and 2013," the agency charged.
VERO Capital and its three principals were charged with, among other things, willfully violating Sections 206(1), (2) and (4) of the Advisers Act and its Rule 206(4)-8, all of which prohibit fraud conducted by an adviser. In addition, VERO Capital was charged with willfully violating Section 206(3), which prohibits an adviser from acts as a principal for his or her own account, and Section 206(4) and its Rule 206(4)-2, the Custody Rule. An attorney representing VERO Capital and the three principals charged could not be reached for comment.