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News March 23, 2015 Issue

SEC Charges Firm with Conflicts of Interest Involving Inter-Fund Loans

Almost as if to demonstrate Asset Management Unit co-chief Julie Rieweís point (see story this issue), the SEC on March 16 settled a case involving multiple conflict-of-interest charges against an adviser and its owner.

The charges revolve around the firmís alleged failure to disclose inter-fund loans among the funds it managed. What makes the SECís conflict-of-interest point especially well is that the agency is not alleging significant financial damages, as the loans were all repaid. The main violations in the SECís eyes were simply that the inter-fund loans were not adequately disclosed, and therefore constitute conflicts of interest.

"Fund advisers should take special note about one aspect of this case: the SEC alleged fraud and imposed significant penalties and undertakings even though the agency did not allege any harm to investors," said Zaccaro Morgan partner Nicolas Morgan. "This demonstrates the importance the SEC places on disclosure of conflicts of interest arising from related-party transactions even in the absence of any monetary harm to investors."

Foley Hoag

partner Daniel Marx made a similar point, noting that Riewe, in her speech, "rejected the notion that there is a Ďno harm, no foulí defense to conflicts charges. The settlement seems to reinforce that view."

The only remedy the SEC took to address financial harm was that the firm, as part of the settlement, "had to disgorge more than $239,000 for management fees it improperly charged in regard to the loans," said

Mayer Brown attorney Adam Kanter. The settlement also imposed a civil money penalty of $250,000 and required the firm to retain an independent monitor.

The case

The administrative order instituting the settlement was with New York City-based adviser

Stilwell Value and its owner and managing member, Joseph Stilwell. From at least 2003 to 2013, the firm directed certain of the funds it managed to make a series of loans totaling $20 million to other funds it managed in order to make investments and repay margin, the SEC said.

"The Stilwell administrative order alleges precisely the type of conflict of interest highlighted by Riewe," said Morgan. "She mentioned, among other things, related-party transactions as a source of potential conflict of interest, and in this case the SEC alleged that certain of the funds under common management loaned money to other of the related funds."

"The settlement includes no allegations of financial harm to, or monetary loss by, the firmís investors," said one of the attorneys representing Stilwell Value and Joseph Stilwell. "Consistent with Joseph Stilwellís and the firmís good faith efforts to put their investorsí interests first at all times, there is no allegation that there was any improper financial gain. Both Stilwell and the firm are happy to resolve this civil matter and put it behind them."

Among the loans Stilwell Value allegedly made were undocumented loans and public company loans.

Undocumented loans

Stilwell Value caused several of its funds to lend or transfer more than $11 million to certain other funds it managed from at least 2003 through mid-2010 so the borrower funds could purchase securities, the agency said. "While these loans were generally of a relatively short duration Ė lasting from a period of days to six months Ė none were documented and no terms (such as interest or maturity) were established at the time they were made. Instead, [Stilwell Value] directed the borrower fund to repay each loan and determined the interest rate after the fact and at [the firmís] discretion."

The loans presented actual or potential conflicts of interest, the agency said, because the firm was:

  • Directing the lender funds to make the loans,
  • Determining the loan terms, and
  • Determining when and whether the borrower funds repaid the loans.

A November 2006 loan for $2 million was disclosed in one fundís 2006 audited financial statements, but the SEC said the disclosure was inadequate because few of the fundís investors received the audited financial statements and because the loan was made eight months before the disclosures in the financial statements appeared. "Investors (even those who requested and received the financial statements) were not informed of the conflicts at the time they arose," the agency said.

Public company loans

One of the firmís funds invested heavily in an unnamed public company beginning in 2008, the SEC said. By 2009, the public company stock comprised virtually all of the fundís assets. The fund was therefore unable to generate liquidity without selling the public company shares, something the firm did not want it to do. Stilwell, the firm owner, also "personally held over $1 million worth of [the] public company stock," the agency said.

The fund needed cash, so the firm directed three of its other funds to make a series of loans totaling approximately $7.8 million from late 2008 through 2009 to the fund invested in the public company. When the borrowing fund proved unable to pay interest or principal on the loans, the firm either directed the fund to borrow from other firm funds, or allowed the borrowing fund to default, "without adequately disclosing these borrowing arrangements, the defaults, or [the firm ownerís] personal interest in the transactions to the funds or the fundsí investors," the SEC said.

The borrowing fund used the cash from the loans to acquire or maintain its position in the public companyís stock, to repay margin loans it took to acquire public company stock, and to repay a prior loan from one of the firmís funds (one in which Stilwell, the firm owner, had an approximately 24 percent interest).

Inadequate disclosure

The SEC alleged that Stilwell Value failed to provide proper disclosure in a number of communications, including:

Form ADV. Neither of the firmís filings, one in February 2012 and the other in December 2012, disclosed Stilwell Valueís inter-fund lending, "nor did they disclose the potential or actual conflicts of interest presented by such lending," the agency said.

  • Offering documents. The fundsí offering memoranda and limited partnership agreements allegedly "did not provide expressly" that the inter-fund loans would be made or disclose the conflicts of interest.
  • Audited financial statements. The SECís problem with a number of these was that many were not available to investors unless they specifically requested them, but few investors did so. In other cases, the disclosures were "limited," the agency said, and were inadequate in terms of alerting investors to conflicts of interest.
  • Monthly capital statements sent to investors. An auditor sent some investors a monthly email summarizing the value of their investments in the firmís funds. Starting in or about Spring 2011, the emails contained a disclosure saying that one of the funds had securities that were worth less than the amount of borrowed funds and that, therefore, "the value of your investment is currently shown at zero." This disclosure, however, allegedly failed to disclose that the source of the borrowed funds was other Stilwell Value funds, that the fund that borrowed the money was in default on its loans, and that Stilwell Value and Joseph Stilwell had not exercised a personal guarantee he provided for loan repayment.