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News August 28, 2017 Issue

Fund Managers Should Disclose Before Using One Fund to Prop Up Another

Recipe for a conflict of interest: An adviser managing two funds causes one fund to invest in the second – but fails to disclose the investment to the investors of the first fund. The fund receiving the investments uses them to finance and help grow the advisory firm.

Sound far-fetched? Not according to the SEC, which last month reached a settlement with Tacoma, WA-based advisory firm Columbia River Advisors and two of its principals to settle allegations not unlike these. As part of the settlement, the three had to pay $135,000 in fines.

"The case involves self-dealing – a serious type of conflict in which the adviser is benefiting at the expense of the fund investors," said Ropes & Gray partner Jeremiah Williams.

"While the monetary penalties are not large, this case touches on a number of recurring themes in recent SEC enforcement actions," he said. "First, the settlement originated out of an SEC examination, which continues to be an important source of cases for the Division of Enforcement. Second, it demonstrates the agency’s ongoing focus on conflicts of interest – which is at the heart of most enforcement actions."

"The takeaway for chief compliance officers is to make sure that 1) funds are treated equitably, and 2) the adviser isn’t receiving an improper benefit at the expense of a fund," Williams said. "In this case, the conflict appears to be obvious and the conduct appears to be intentional, but often the nature of the conflict is more subtle."

"Advisers that fail to disclose material conflicts of interest place themselves at risk of an enforcement action, especially where, as here, the conflict involves an investment with a related party," said Mayer Brown partner Matthew Rossi. "This settlement shows that undisclosed conflicts remain an SEC priority for advisers to private funds. The SEC has in the past, and will likely continue to take action against advisers that fail to timely disclose conflicts even if the investments giving rise to those conflicts are profitable for investors."

The firm and the funds

Columbia River, according to the SEC’s administrative order instituting the settlement, is a registered investment adviser with $372.7 million in assets under management and about 1,300 advisory clients. Between 2012 and 2015, the advisory firm, along with co-founders Benjamin Addink and Donald Foy, managed two investment funds.

Addink, who owned 33 percent of the firm, served the firm in a number of capacities, including as managing director for new business development, chief financial officer, and a portfolio manager for the two investment funds, the agency said. Foy, who also owed 33 percent of Columbia River, served as the firm’s chief executive officer and chief compliance officer, as well as a portfolio manager for the two investment funds. Both men were compensated by member draws, according to the administrative order.

"Not having an independent CCO is never a good idea," said Eaton & Van Winkle partner Paul Lieberman. "The principals of a firm should consider their AUM, their number of clients and the nature of their business when deciding on compliance matters. A firm that doesn’t have an independent CCO may end up spending a lot more."

Of the two funds, Fund I, formed in January 2012, was started by Addink and Foy as an alternative investment vehicle for Columbia River clients to invest in assets not tied to stocks and bonds. The SEC described Fund I’s offering circular as saying that "the fund’s objective was to achieve returns by principally engaging in trading foreign currencies using a proprietary technical analysis strategy." The fund could also invest in other asset classes, including securities. Columbia River was the fund’s general partner and investment adviser, with Addink and Foy serving as the limited partners – and all but one of Fund I’s limited partners were also Columbia River advisory clients, the SEC said. At the end of 2012, Fund I had net assets of approximately $5.5 million.

The second fund, Fund II, was formed by Addink and Foy in April 2012. It’s offering circular "stated that it planned to raise money from investors and lend it to Columbia River to buy investment advisory books of business from other advisory firms," the agency said, which Fund II did through promissory notes that paid an annual interest rate of 8.25 percent for terms ranging from 4 ½ to 5 ½ years. Columbia River, as it did with Fund I, served as Fund II’s general partner and investment adviser, with Addink and Foy as its portfolio managers. All of Fund II’s limited partners were Columbia River clients, and two of the limited partners were also invested in Fund I, the SEC said.

"Columbia River did not charge Fund II a management fee because Columbia River was paying Fund II interest on the loans from the fund and Fund II required less management on Columbia River’s part than Fund I because its only business was to lend money to Columbia River," the agency said. At the end of 2012, Fund II had net assets of approximately $3.6 million.

Investments and disclosure

Although the adviser initially invested Fund I’s assets in foreign currency trading and other already disclosed investment types, "as a result of the difficulty in fully executing the foreign currency trading strategy, significant assets in Fund I were not invested in foreign currency," the SEC said, and "accordingly Addink and Foy sought out other investments."

This is where the problem began. "Beginning in June 2012, they caused Fund I to invest a portion of its capital in Fund II, which earned an 8.25 percent annual rate of return (less expenses)," the agency said. "By the end of 2012, Fund I had about $3.1 million invested in Fund II, which was approximately 55 percent of Fund I’s total assets." What this meant was that "the majority of Fund I’s assets were not invested in foreign currency trading, but were instead invested in Fund II, which Columbia River used to finance and grow its investment advisory business."

But what about how these investments differed from what the SEC said were the investment descriptions in Fund I’s offering circular? That’s the rub, according to the agency’s administrative order. "Respondents failed . . . to inform the Fund I investors before making the investments or disclos[ing] the conflict of interest, namely that the investment from Fund I into Fund II would help to grow Columbia River’s investment advisory business and potentially increase its profits."

"Because Columbia River acted as a general partner for both Fund I and Fund II and respondents stood to benefit from Fund I’s investment in Fund II, they could not consent to the investment on Fund I’s behalf," the agency said. "Addink and Foy were aware that a conflict of interest existed, but did not take reasonable steps before the investment was made to ensure that it was disclosed to the Fund I investors. One of the results of this was that, between June 2012 and February 2014, Fund I investors paid Columbia River a management fee on the portion of Fund I’s assets that were invested in Fund II, the agency said. "Had the Fund I investors invested directly in Fund II, they would not have been subject to a management fee on the Fund II investment," the SEC said, noting that prior to the beginning of this case, the advisory firm refunded the management fees in question to the investors affected.

Custody Rule violation

Then there’s the SEC allegation that Columbia River violated Rule 206(4)-2, the Custody Rule. The advisory firm, according to the administrative order, chose to distribute audited financial statements to Fund I’s and Fund II’s limited partners, rather than undergo an annual surprise examination by an independent public accountant.

The problem, the agency said, was that in fiscal year 2012, the auditor hired by Columbia River, while recommended by its outside counsel and registered with the Public Company Accounting Oversight Board, was not subject to PCAOB inspection, "and therefore was not qualified to perform the audits under the Custody Rule." This was discovered during an examination of the advisory firm by the SEC staff, the agency said.

"Be careful who lawyers give you as a potential auditor," said Lieberman. "To the extent that a lawyer does not give you a proper auditor, you may need a new law firm. You cannot blindly rely on an attorney’s recommendation."

Columbia River, Addink and Foy were censured as part of the settlement, and Columbia River agreed to retain an independent compliance consultant. All three agreed to pay civil money penalties: $80,000 from Columbia River, $25,000 from Addink, and $30,000 from Foy. Attorneys representing the three respondents did not respond to voice mails or emails seeking comment.