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News November 23, 2015 Issue

Failure to Disclose Change in Investment Strategy Likely to Draw SEC Ire

Firms that plan to change a fundís investment strategy would be wise to let their clients know before, rather than after, they execute the change. Those that donít may not only face unhappy investors, but the wrath of the SEC.

Two UBS advisory firms facing†charges for allegedly doing exactly that†recently settled with the SEC. As part of the settlement, the two firms had to pay approximately $17.5 million in disgorgement, interest and penalties.

The SEC alleged that UBS Willow Management misrepresented and omitted information in regard to a material change in investment strategy for a fund it managed. The fund was marketed since its inception in 2000 as investing primarily in distressed debt, a strategy based on the debt increasing in value Ė and, in fact, until 2008, UBS Willow Management did indeed invest the fundís assets in accordance with that strategy.

However, the advisory firm "changed course in 2008 and, instead of focusing on investment in debt issued by troubled companies, it had the fund purchase large quantities of credit default swaps, a strategy predicated on the debt decreasing in value," the SEC said. The credit default swaps rose from less than 2.6 percent of the fundís market value in 2008 to more than 25 percent of the fundís market value by March 2009. Unfortunately, instead of the strategy working, the fund started incurring "big losses" from these holdings, ultimately leading to its liquidation in 2012, the agency said.

While the change in investment strategy was bad news for the firm and its investors, it was not, by itself, illegal. What brought the SEC Division of Enforcement on board was that the change in strategy deviated from the fundís offering memorandum, and that neither investors nor the fundís board were told of the change by UBS Willow Management.

UBS Fund Advisor, a second UBS adviser that controlled and supervised UBS Willow Management, allowed the strategy change to occur without disclosure to investors or to the fundís board of directors, the SEC said.

"Advisers must provide investors and fund boards with accurate information about a fundís investment strategy," said SEC Enforcement Division Asset Management Unit co-chief Julie Riewe. "Here UBS Willow Management completely reversed the fundís strategy Ė from investing in distressed debt to betting against it Ė without adequately disclosing the change."

"This case highlights the SECís continuing scrutiny of differences between adviser representations to investors and actual practices," said Zaccaro Morgan partner Nicolas Morgan. "The issue may have caught the SECís attention because of the purportedly dramatic, 180 degree shift in strategy, but whatever the cause of the SECís interest, the case demonstrates the need for regular monitoring of communications with investors to ensure that actual practices match what the adviser is communicating."

The strategy change

When the fund was investing in distressed debt, as the SEC said UBS Willow Management promised in the fundís offering memorandum, the adviser was operating under the thesis that debt would increase in value, which was a long-credit position. But when UBS Willow Management switched in 2008 from investing in distressed debt to credit default swaps, it chose to short credit, operating under the thesis that debt would†decrease in value, the agency said.

"Indeed, by fall 2008, the fund had transitioned from its historical long-credit position and become net short credit," the SEC said. "Thereafter, the fund†remained net short credit through its credit default swaps exposure. Ultimately, the credit default swaps exposure resulted in significant losses at the fund and, in part, as a result of those losses, the fundís board of directors liquidated the fund in 2012."

Stern Tannenbaum partner Aegis Frumento, while†acknowledging that the SECís enforcement action may seem like a clear-cut case of failure to disclose, said the adviserís alleged wrongdoing "makes for good SEC headlines, but is not really so clear."

The SEC "is taking the credit default swap hedge that the adviser used out of context," he said. "The adviser changed course on investing in distressed debt in 2008, when the credit crisis struck." Extremely tight credit in 2008 made it very unlikely that any distressed debt was going to make money and betting that interest rate spreads were going to widen by going short was the only way to go. Back in 2008 we all expected spreads to widen, thinking they couldnít possibly get tighter. Well, they did."

One can argue that the adviser should have notified†investors, Frumento said, "but only about 25 percent of the fundís investments went into credit default swaps. Is a change in only a quarter of a fundís portfolio a change in investment strategy, or is that just the Ďoccasionalí use that was already disclosed?"

Perhaps the adviser should have disclosed the changing economics as the credit default swaps became more critical to the fundís results, he said, but "itís hard to judge when to make such a disclosure in a changing and unpredictable environment like that." Frumento described the SECís position that the change in investment strategy contributed to significant losses for the Fund as "nonsense," saying that "in the credit crunch of 2008, a distressed debt fund was a sinking ship. The credit default swap short was an intelligent attempt to keep the boat afloat until interest rates rose and spreads widened. The losses happened because spreads didnít widen as everyone hoped, which means that without the credit default swaps, the fund might have collapsed sooner. But those realities often are lost on the SEC when it wants to score a regulatory point."

Questions of disclosure

"Once the fund had become net short credit, UBS Willow Management misrepresented the fundís investment strategy (and its risks) in various communications to investors, prospective investors and the Board, and caused the fund to misrepresent the strategy in filings with the Commission," the agency said. Specifically:

  • Board disclosure. "UBS Fund Advisor, acting on†behalf of UBS Willow Management, met regularly with the board, but from fall 2008 to May 2009 it failed to ensure adequate disclosure to the board of the fundís change in investment strategy," the SEC said. "Further, from May 2009 to August 2011, UBS Willow Management did not adequately disclose significant, known risks posed by the fundís large credit default swaps exposure." As an example, the agency alleged that, after receiving stress test results showing large potential credit default swap losses, UBS Fund Advisor did not inform the board of the test results, even though it received them on the morning of the May 2009 board meeting. Separately, UBS Willow Management did not inform the board of the "substantial cost of maintaining the credit default swap positions, which, by 2010, annually exceeded 25 percent of the fundís net assets," the agency said.
  • Offering memorandum. Since UBS Willow Management did not update the fundís offering memorandum to take account of the change in strategy, that meant that from fall 2008 until the fund was liquidated in 2012, "UBS Willow Management provided prospective investors with a materially false offering memorandum," the SEC said.
  • Marketing brochure. From fall 2008 to May 2009, UBS Willow Management provided prospective†investors "with a marketing brochure containing false statements about the fundís investment strategy," the agency said. As an example, it noted that the brochure identified a "general widening of credit spreads," which is a risk of a long-credit distressed debt strategy, as a potential risk. But, in fact, at that time, the SEC said, "the fundís short-credit exposure meant that the actual risk was from tightening†[emphasis SEC] credit spreads." Another example the agency provided was that the brochure referred to the fundís "occasional" use of credit default swaps, "when, in fact, credit default swaps [were] the primary driver of the fundís performance at†that time."
  • Investor letters. UBS Willow Management, according to the SEC, from fall 2008 to August 2011, sent out investor letters with false or misleading statements about the fundís investment strategy. "For example," the agency said, "the quarterly letters during this†period referenced benchmark indices inapplicable to the fundís short-credit strategy." In addition, the SEC alleged that there was also a misleading statement about the fundís leverage. "The fourth quarter 2008 letter represented that the fund did not use leverage," the agency said. Although the fund did not utilize leverage in the traditional sense of investing with borrowed money, the fund relied heavily on credit default swaps, which [have] inherent synthetic leverage." It was only in the August 2011 investor letter that UBS Willow Management provided fund investors with a complete explanation of the effect of the credit default swap positions on fund performance and the risks posed by the exposure, the SEC said.
  • Registration statement and other reports. From fall 2008 until the fund was liquidated in 2012, "UBS Willow Management caused the fund to make filings with the Commission that misrepresented the fundís investment strategy and principal risk factors," the SEC said. For instance, according to the agency, in each of the fundís semi-annual and annual Forms N-CSR from December 31, 2008 through liquidation, "the fund stated that it sought to achieve its†investment objective of maximizing total return Ďwith low volatility by making investments in distressed†assets,í" the agency said. "In fact, the increased use of credit default swaps was high [emphasis SEC] volatility, with performance driven by shorting [emphasis SEC] distressed assets." In addition, according to the SEC, UBS Willow Management did not amend the fundís registration statement on Form N-2 to address the change in investment strategy.

Violations and penalties

The SEC charged UBS Willow Management with, among other things, having willfully violated Sections 17(a)(2) and 17(a)(3) of the Securities Act, which, respectively, prohibit making untrue statements of material fact, and engaging in fraud. UBS Fund Advisor was charged with violating Section 203(e)(6) of the Advisers Act for failing to reasonably supervise UBS Willow Management to prevent violations of the federal securities laws. The advisory firm was also charged with having willfully violated Section 206(2) of the Advisers Act, which prohibits fraud, as well as its Rules 206(4)-8(a)(1) and 206(4)-8(a)(2), which, respectively, prohibit making untrue statements of material fact, and engaging in fraud. An attorney representing both UBS Willow Management and UBS Fund Advisor did not respond to a voice message or an email seeking comment.