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News August 21, 2017 Issue

Private Fund Adviser and Owner/CCO Settle Multiple Charges with SEC

The SEC is long past the day of being unfamiliar with private fund advisers. It knows what to look for when it investigates and isn’t shy about enforcement actions. When it finds a situation where the owner of the advisory firm is also the chief compliance officer, don’t be surprised if it makes an example of the case.

Chief compliance officers, after all, have been repeatedly described by the agency as its "partner" in ensuring that a culture of compliance, as well as of ethics, is the norm at advisory firms. While the SEC has said it does not target CCOs, it has also said that when it finds a situation where a CCO has contributed to compliance problems, it will not hesitate to do so.

Consider the agency’s recent settlement with Brian Kimball Case, and his two advisory firms, Bradway Financial and Bradway Capital Management. Case is the sole owner, managing director and CCO of both firms. In the settlement, the SEC hit Case and his firms with at least six allegations:

  • Invalid registration exemption. The agency charged that Bradway Capital improperly relied on the private fund adviser exemption from registration in Rule 203(m)-1 under the Advisers Act, nor did it qualify for any other registration exemption;
  • Inflated valuation. Bradway Capital’s investor statements contained "inflated values" for investments held in two of its private funds, the SEC said, although the settlement made a point of noting that neither Bradway Capital nor Bradway Financial received any fees based on the inflated valuations;
  • Custody Rule non-compliance. The agency alleged that both Bradway Capital and Bradway Financial failed to comply with Advisers Act Rule 206(4)-2;
  • Compliance Program Rule non-compliance. The two advisory firms also allegedly did not comply with Rule 206(4)-7;
  • Misuse of fund assets. The SEC stated that the two advisory firms and Case improperly used those assets to pay their legal fees in connection with the SEC’s investigation;
  • Failure to determine if fund investors were qualified clients. Bradway Financial contracted to earn a performance fee for managing a fund without first determining whether the fund’s investors were qualified clients, the agency said.

As part of the settlement, Bradway Financial and Bradway Capital agreed to retain an independent compliance consultant for at least two years, and certified in writing that they would comply with the conditions of the compliance consultant’s work. In addition, both firms were censured, and Case was barred from acting as a chief compliance officer in the securities industry for at least three years. Finally, the three respondents, collectively, agreed to pay a $150,000 civil money penalty. An attorney representing the three did not respond to a voice mail or email seeking comment.

"While the fact that no new areas were targeted may bring comfort for some," said Paul Hastings partner Tram Nguyen, the settlement "signals that the agency remains focused on private fund advisers, notwithstanding changes in SEC personnel."

Here’s how those allegations flesh out, according to the SEC’s administrative order that instituted the settlement:

The registration exemption

Bradway Financial was the investment adviser to a certain fund from 2006 to 2013. Case, after consulting with a compliance consultant, in 2013 formed Bradway Capital, in part to avoid the obligation of the Custody Rule, according to the agency. "He understood that Bradway Financial would not have to comply with certain Advisers Act rules in advising a private fund, such as Rule 206(4)-2 . . . if the [fund] was advised by an exempt reporting adviser (Bradway Capital) instead of an adviser registered with the Commission (Bradway Financial)," the SEC said. "Case hoped to save on expenses by not having to obtain an annual audit for the [fund] or a surprise examination to comply with the Custody Rule."

Bradway Capital based its registration exemption on the fact that it was an adviser to private funds with assets under management of less than $150 million. But that was not enough, according to the agency. "It was not entitled to rely on this exemption because Bradway Financial and Bradway Capital were under common control and operationally integrated." To support its point of view, the SEC notes in the settlement order that the two firms were both owned by Case, shared the same employees, operated in the same office, and share the same technology systems.

Therefore, the agency said, "Bradway Capital was required to comply with the rules under the Advisers Act applicable to investment advisers registered or required to be registered with the Commission under Section 203(a) of the Advisers Act."

"The devil was in the details here," said Bell Nunnally partner Robert Long. "Although the idea of having a separate adviser that was exempt from registration may have been a good idea on paper, Bradway Capital, according to the SEC’s administrative order, was operationally integrated and under common control with Bradway Financial, and therefore Bradway Capital could not rely on 203(m)-1."

Inflated valuation

According to the SEC, Case and Bradway Capital sent "periodic valuation statements" to fund investors. These statements, the agency said, said that they were "fair market value estimates" of the fund’s investments. But "while they occasionally employed the services of third-party valuation providers to arrive at valuations, Case – despite not having any valuation experience or training – often assigned his own estimated valuations to [the fund’s] investments."

More specifically, the settlement order states that on June 30, 2015, Bradway Capital sent statements to the fund’s investors that showed inflated fair market value estimates in the following ways:

  • Bradway Capital, in addition to investing fund dollars in private company equity and debt, also invested fund money in shares of a private equity fund, and Case and Bradway Capital received fair market valuation information from the adviser to that private equity fund. Despite this, Bradway Capital reported a fair market valuation for the private equity fund investment "that was approximately three times higher than the fair market valuation of the investment provided."
  • Bradway Capital’s fair market value estimate for a $50,000 investment in a portfolio company showed that the investment was still valued at its original cost, "but the [fund’s] annual tax reporting statement for 2014 reflected that the investment was written off as bad debt."
  • A number of the fair market value estimates for the fund’s other investments "were based on stale information," the agency said.

These inflated valuations were reported on multiple Forms ADV, according to the SEC.

"The case illustrates the importance of taking reasonable steps to arrive at a fair market valuation for illiquid investments," said Long. "Notably, in this matter, the staff took enforcement action on allegedly flawed, inflated valuations even though the valuations did not generate any fees to the respondents."

Custody and the compliance program

The SEC’s allegations involving Custody Rule violations tie into its allegations that Bradway Capital improperly took advantage of a Commission registration exemption. Since the exemption was invalid, Bradway Capital would have had to comply with Custody Rule requirements – and this, the agency said, the firm did not do.

"From 2013 to 2015, Bradway Capital had custody of [two funds’] assets but did not subject the funds to an annual audit or obtain a surprise examination to verify the assets held by Bradway Capital," the SEC charged. In 2016, a third-party auditing firm began auditing the funds for those two years, with the completed audited financial statements to be delivered to investors in the funds upon completion.

The settlement order also notes that Bradway Financial had custody of certain other clients’ assets, "and some of those assets were not maintained by a qualified custodian." These assets, the SEC said, included stock certificates and blank signed authorization forms from certain clients. "Despite having custody of these other client assets, Bradway Financial did not obtain surprise examinations during the time period 2011 to 2015."

As for its failure to comply with the Compliance Program Rule, the agency alleged that Bradway Capital failed to adopt or implement written compliance policies and procedures. As for Bradway Financial, although it worked with a compliance consultant, the SEC said that it "adopted an off-the-shelf compliance manual that was not tailored to the type of business it conducted, and its compliance policies and procedures did not address registration or exemption from registration as an investment adviser. In addition, Bradway Financial failed to conduct annual reviews of the adequacy and effectiveness of all its compliance policies and procedures."

The other allegations

Here’s what else the agency charged:

  • Qualified client vetting. Not all the investors in the fund apparently were qualified clients as defined by Rule 205-3(d) under Adviser Act Section 205(e), the SEC said. "When he conducted his accredited investor review, Case did not conduct any review to determine if each investor in the [fund] also satisfied the definition of qualified client." The accredited investor review was conducted upon the drafting of the [fund’s] operating agreement, which contained a performance fee provision. The settlement notes that, "to date, Bradway Financial, Bradway Capital and Case have not charged the [fund] any performance fee for investors who may have received a return or partial return of their principal investment and profits."
  • Use of fund assets to pay legal fees. Case, according to the settlement order, "negligently" relied on an indemnification provision in the fund’s operating agreement as the basis for using fund assets to pay the legal fees incurred by the Division of Enforcement staff’s investigation. "However, with respect to legal costs and expenses, the operating agreement provided that the [fund] would pay such costs ‘directly relating to the ongoing activities’ of the fund. Approximately $65,000 in legal fees that were paid with [fund] assets did not directly relate to the fund’s ongoing activities because the fees were for legal services provided to the investment advisers (and not the fund), and the governing document did not otherwise authorize [the respondents] to charge the fund for their own legal costs." That said, the administrative order noted, Case, Bradway Financial and Bradway Capital have since repaid the fund for all of the legal fees paid by it in connection with the investigation.