Accurate Small Print Disclosures Will Not Make Up for Misrepresentations
"It’s in the written materials" is not an adequate defense for firms whose representatives otherwise misinform clients about the risk level of investments. Advisers need to review all representations, written and oral, to ensure that they provide accurate and consistent disclosure.
Two Citigroup affiliates learned this lesson on August 17, after they agreed to pay almost $180 million in disgorgement and interest to settle SEC charges that they defrauded investors in two hedge funds. Representatives of the two affiliates, Citigroup Alternative Markets (CAI) and Citigroup Global Markets (CGMI), allegedly told investors that investments in the hedge funds were "safe, low-risk and suitable for traditional bond investors," even though the funds "later crumbled and eventually collapsed during the financial crisis," the agency said.
"Firms cannot insulate themselves from liability for their employees’ misrepresentations by invoking the fine print contained in written disclosures," said SEC Division of Enforcement director Andrew Ceresney. "Advisers at these Citigroup affiliates were supposed to be looking out for investors’ best interests, but falsely assured them they were making safe investments even when the funds were on the brink of disaster."
The affiliates and the funds
From 2002 through 2008, CAI, which served as the investment manager for the two hedge funds, and CGMI, which served as the financial adviser to certain clients who invested in the funds, raised almost $3 billion from approximately 4,000 investors, according to the administrative order instituting the settlement. Both funds collapsed in 2008, "resulting in billions of dollars in losses," the SEC said.
One of the two funds was a municipal arbitrage fund that purchased municipal bonds and used a Treasury or LIBOR swap to hedge interest rate risks. It employed 8 to 12 times leverage, the SEC said. The second fund, employing 5 to 6 times leverage, was a multi-strategy fund that invested in fixed income strategies, such as collateralized debt obligations and asset-backed securities. It also invested in the first fund.
Investors in the funds paid what amounted to two sets of fees: advisory fees for investment advice, including placement agent fees relating to their investments to CGMI; and fund management fees to CAI. All in all, investors in the two funds directly or indirectly paid the two Citigroup affiliates approximately $213 million in fees, of which they returned approximately $73 million as compensatory payments after the funds collapsed, the agency said.
Statements in marketing documents for the funds said that the funds "should not be viewed as a bond substitute" and also made clear "the risk of principal loss," the agency said. Despite these written disclosures, the agency said that the Citigroup affiliates’ "financial advisers and the fund manager misrepresented the funds’ risks and performance to advisory clients," describing them as "suitable for traditional bond investors."
"The most interesting aspect of this case is that the SEC alleged fraud despite the fact that the investment adviser accurately disclosed information about the risk of principal loss, but individual financial advisers orally ‘minimized the significant risk of loss,’" said Zaccaro Morgan partner Nicolas Morgan.
Specifically, the agency alleged that "certain financial advisers and the fund manager orally minimized the significant risk of loss resulting from, among other things, the funds’ investment strategy and use of leverage. Investors were also told that the biggest risk facing [one of the funds] was the adoption of a flat income tax by the federal government."
Going further, financial advisers encouraged many of their clients to sell chunks of their bond portfolios so they could invest in the funds, according to the agency. "In late 2007, financial advisers and the fund manager continued to offer and sell [one of the funds] as a safe, low-risk investment, even though both funds … began experiencing increased margin calls and liquidity problems in the second half of 2007 that continued until the funds collapsed," it said.
The SEC, in its administrative order, also made clear that this problem was not limited to representatives selling shares in the funds. "The fund manager was involved in virtually all fund-related communications with the financial advisers and investors," the agency said, noting that the fund manager and its staff were responsible for drafting and reviewing offering materials for the funds, crafting sales pitches to investors, training sales personnel, drafting quarterly investor reports, and disclosing interim performance.
"Throughout the fund offerings and fund operations, the fund manager and the fund manager’s staff at [one of the funds] met with prospective investors and responded directly to inquiries from the financial advisers concerning the funds without sufficient oversight governing these oral communications," it charged.
Finally, one of the funds failed to implement a system that would have provided a check on the fund manager’s authority or that would "ensure that the fund manager’s communications with investors and financial advisers … were accurate and not misleading."
"The takeaway for investment advisers here is to ensure that oral statements made by employees must be accurate and consistent with written representations to investors," said Morgan. "A firm’s efforts and expenses to make accurate disclosures in written form should not be undermined by contrary oral representations by individual employees."
Doing so, however, requires having the right tools in place. "For most advisers, it isn’t practical to actually put a compliance person in the room, but policies and procedures—and training—are key to having good controls," said Mayer Brown attorney Adam Kanter.
"Another lesson," he said, "is that advisers can’t ignore developments involving their funds when they are marketing those funds. You can’t pretend everything is business as usual, particularly in the face of specific questions from investors, when the reality isn’t quite that rosy."
Failure to disclose
The SEC also alleged that, in addition to misrepresenting the funds’ risk levels, the two Citigroup affiliates failed to disclose internal risk warnings, specifically:
An internal rating system at one of the advisers listing the funds as having "significant risk to principal."
Performance back-testing on a hypothetical portfolio for one of the funds showed that an investment in the fund carried a "far greater risk than that described to investors."
Liquidity issues at one of the funds, including the sale of $2 billion in fund assets to meet margin calls, or the fund manager’s request for a $200 million loan from either the CAI or the Citigroup parent company.
In addition, CAI allegedly orally misrepresented the condition of one fund in late 2007 and early 2008 and the fund’s ability to survive a declining market. "The fund manager continued to tell investors that the biggest risk to the fund was the adoption of a flat income tax by the federal government. The fund manager reassured investors just weeks before the fund collapsed that the risk of loss was minimal," the agency said.
Policies and procedures
CAI did not have policies and procedures in place that would have prevented the misrepresentations made to investors, the SEC said. "The fund manager had virtually complete control of the information disseminated to investors without sufficient review to ensure that those communications were accurate. CAI employed its own sales personnel, or wholesalers, who were educated on funds by the fund manager, which "drafted sales pitches for the wholesalers that were not subject to review or approval by anyone outside of the fund manager’s staff, including anyone in the compliance group. Those sales pitches and talking points misrepresented the risks of the funds."
Violations and penalties
While neither Citigroup affiliate admitted or denied guilt as part of the settlement, both were alleged by the SEC to have willfully violated Sections 17(a)(2) and 17(a)(3) of the Securities Act, which prohibits fraud. In addition, CAI was charged with having violated Section 206(4) of the Advisers Act and its Rule 206(4)-7, the Compliance Program Rule, which requires, among other things, that advisers adopt and implement written compliance policies and procedures; and Rule 206(4)-8, which prohibits advisers of pooled investment vehicles from making untrue statements of material fact to investors.
Interestingly, no civil money penalty was charged to either Citigroup affiliate. No reason was given for this omission. The law firm representing the fund chose not to comment on the matter.