Failure to Disclose Reserve Funds and Related Fees May Lead to Enforcement
Reserve funds are sometimes created and used by advisory firms to "smooth" investor earnings or to ensure redemption requests can be met. Advisers that do so must disclose such a fundís existence, ensure that fee policies are disclosed and avoid conflicts of interest. Failure to do so may lead to problems with examiners and agency enforcement.
St. Louis-based advisory firm Institutional Investors Advisory Company, a 47-year-old advisory firm with more than $350 million in assets under management, recently settled charges with the SEC that it did not disclose a number of developments and practices involved with an investment fund it managed. The fund was created by the Catholic Church as an investment vehicle for not-for-profit religious, charitable and educational clients, and is exempt from the definition of "investment company" as defined by the Investment Company Act of 1940. The disclosures called into question by the agency were:
Creation of a separate reserve fund in 1993. The purpose of the reserve fund, created under the direction of IIAC owner and president William Zielinkski, was to "smooth investment earnings by either transferring Ďexcessí investor profits into the reserve when investment profits exceeded a fixed rate of return. . . or by distributing funds from the reserve to [the investment fundís] investors if profits fell below the ístated returnĎ to ensure investor earning met the stated return," according to the SECís administrative order instituting the settlement.
Not providing undistributed earnings to investors who withdrew from the investment fund. "Neither Mr. Zielinski nor IIAC sufficiently disclosed to the. . . investors until 2014 that upon withdrawing from [the investing fund] they would not receive all of their profits," the agency said.
Including reserve fund profits in calculation of†advisory fees. "Starting in 2001," the SEC said, "IIACís advisory fee was applied to all of [the investment fundís] assets, including the investor profits that [the investing fund] retained in the reserve fund." This practice, the agency said "created a conflict of interest for the IIAC Ė the more of the [investment fundís] income that the [investment fund] retained in the†reserve (as opposed to distributing it to investors), the more fees IIAC earned."
Zielinski, in addition to serving as IIACís president, is also the president of the investment fund and sits on the board of directors for both IIAC and the investment fund, along with members of his family who are associated with IIAC, the agency said.
"The starting point for this settlement is the fact that the adviser advised a fund and institutions that invested in that fund, creating the potential for a conflict of interest," said Paul Hastings partner Nicolas Morgan. "The SEC has made it clear that it will scrutinize such conflicts of interest, and, indeed, this case presents the latest in a long line of SEC enforcement actions taking an advisor to task for failing to adequately disclose conflicts."
The settlement "reinforces the need for effective processes and accounting to manage investors when withdrawing assets, that no asset or investment in which investors have an interest are overlooked, and that the investors receives their full share of investments in which they participated," said Faegre Baker Daniels partner David Porteous.
An attorney representing IIAC said that the company, "as provided in the order, neither admits nor denies the orderís findings or conclusions. IIAC elected to settle the matter in a way that avoided disruption to its client, as well as avoided the possibility of costs being†imposed on its client."
The advisory relationship
From 1970 until approximately 2002, the institutions that Zielinski advised and that invested in the fund signed what are called "managing agency agreements"(MAA) with IIAC. These agreements, which the SEC said were utilized by the advisory firm in an attempt to ensure compliance with the fundís tax exempt status, provided that IIAC was "ultimately responsible" for distributing net income to the investors. The agreements also stated that "í[t]he entire amount of income collected by [the investment fund], less operating expenses of [the investment fund], will be distributed to the [investors who signed the agreement] on a pro-rata basis,í" the agency said.
"Consequently, IIAA owed a fiduciary duty to the [managing agency agreement] investors," the SEC said.
The reserve fund and disclosure
The investment funds in 1993 began using the reserve fund "to provide investors with liquidity, a steady rate of return and protection from potential investment losses in any given month," according the agencyís administrative order.
During the reserve fundís operation, the investment fund provided a "stated return" to investors of between 5 percent and 6.7 percent, the agency said. What this meant was that investment fund profits in excess of that stated return would be transferred to the reserve fund. "Accordingly," the SEC said, "on a monthly basis, [the investment fund] either transfers its investment profits in excess of the stated return established by the board into the reserve or pay investors with funds from the reserve if profits fall below the stated reserve to ensure investor earnings meet the return."
However, investors that withdrew from the investment fund did not receive their pro-rata profit from the†reserve fund at the time of their withdrawal, the agency alleged.
"Neither Mr. Zielinski nor IIAC disclosed the existence of the reserve to the MAA investors when the reserve was first established," the SEC said. "Subsequent disclosures provided to the MAA investors between 2002 and 2013 mentioned the reserve fund in varying degrees of specificity, but none adequately disclosed that the MAA investors would not receive any of their interests in the reserve upon their withdrawal from the [investment fund]."
It wasnít until 2014, according to the administrative†order, that MAA investors were "more fully informed" about their rights in the reserve fund. "From at least January 2011 to April 2014, certain MAA investors did not receive their portion of the reserve upon departing [the investment fund. These MAA investors unknowingly left $1,268,536 remaining in the reserve, i.e., [the investment fund] did not distribute these funds to them upon their withdrawal."
As for the question of charging fees to investors based on their profits in the reserve fund, the SEC alleged that this began in 2001. The disclosure provided to the investors in the MAAs and other disclosure documents was that IIACís advisory fees for managing the investment fund would be a percentage of the "íaverage net asset value of the property held hereunder,í" the agency said.
"This disclosure did not adequately disclose that the assets in the reserve were included in the assets upon which IIACís advisory fees were based," the SEC said. "Also, the disclosure was deficient because it did not†address the inherent conflict of interest that was created when IIAC began generating fees from the reserve."
It was concerns raised by SEC examiners in April 2014 that led to this problem being addressed, according to the agency. At that time, the investment fund "revised its disclosures to the MAA investors to explain that IIAC would charge advisory fees to manage the assets in the reserve," it said. However, from January 2011 to April 2014, the advisory firm received $531,680 in advisory fees from the reserve fund.
Violations and remediation
IIAC was charged in the settlement with violating Advisers Act Section 206(2), which prohibits fraud. The SEC said it considered "remedial acts promptly undertaken" by the adviser, as well as the firmís cooperation with the agency staff in settling the case.
Those undertakings, according to the administrative order, includes IIACís payment of $1.27 million Ė the amount of profits that MAA investors still had remaining in the fund after they withdrew from the investment fund Ė as well as prejudgment interest of $146,740 to an SEC fair fund, which will be used to compensate those investors.
Separate from that undertaking, the agency ordered IIAC to pay $531,680 in disgorgement, $61,507 in prejudgment interest, and a civil money penalty of $250,000. The firm was not censured, nor was it barred from the securities industry.