Multiple and Repeated Compliance Problems Likely to Draw SEC Action
Compliance is more than simply taking steps to satisfy regulators. If followed in spirit, with an eye toward ethics, compliance should be part of a culture where advisory firms do the right thing simply because it is right. In doing so, they will probably find that they are more likely to satisfy SEC requirements and thereby head off potential enforcement actions.
Advisers should consider their own culture of compliance in the wake of a January 3 SEC settlement with an advisory firm, Phoenix-based LKL Investment Counsel and Mark Love, its president and CCO. Among other things, the settlement resolved agency allegations that the firm made multiple misrepresentations on its Forms ADV, failed to produce documents requested by agency examiners, and failed to have written policies and procedures in place regarding how advisory fees would be charged.
These actions, the SEC said in its administrative order instituting the settlement, were in relation to Loveís recommendations to certain LKL clients that they invest in private funds in which he held managerial interests and would receive fees and a share of investment profits. Although the agency said that the clients who invested knew of Loveís involvement with the funds, it alleged that LKL nonetheless stated on its Forms ADV that he had "no outside financial industry activities or affiliations, and no interests in client transactions."
"Every adviser must carefully understand the nature of its own business and its disclosure requirements or face the possibility of being sanctioned severely," said Scarinci Hollenbeck partner Paul Lieberman.
"These violations were accompanied by compliance breakdowns Ė LKL did not conduct requisite annual†reviews and failed to implement its policies requiring full disclosure of Loveís outside activities in LKLís Forms ADV," the SEC said. "Moreover, LKL failed to adopt policies related to advisory fees and made errors in charging and refunding advisory fees totaling approximately $8,500."
"The SECís Enforcement staff recently indicated that it plans to pursue more message cases in its effort to regulate the financial industry. The LKL matter appears to be such a case," said Paul Hastings partner John Nowak. "It should serve as a reminder to advisers of the SECís expectation during the examination process that the examination staffís requests should be met with complete and candid responses. Moreover, it should be used to remind advisers to involve counsel directly or indirectly during the examination process on the more sensitive issues."
As part of the settlement, Love was barred from engaging in a compliance capacity for the indefinite future. LKL was charged with, among other things, willfully violating Advisers Act Sections 204(a) and its Rule 204-3, which require advisers to deliver to clients within 120 days of the end of their fiscal year either a current Form ADV, Part 2A brochure or summary of material changes to the brochure; Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for failing to adopt and implement reasonable written compliance policies and procedures; and Section 207, for making untrue statements of material fact in any registration application or reports filed with the Commission. The firm was censured and ordered to pay a civil money penalty of $100,000. It withdrew its registration with the agency as an adviser in July 2017.
Love was also charged with willfully violating Section 207, as well as willfully aiding, abetting and causing LKLís other violations. He was barred from acting in a compliance capacity for the indefinite future. He was censured and ordered to pay a civil money penalty of $50,000. Attorneys representing LKL and Love did not respond to an email or voice mail seeking comment.
Form ADV problems
Following is a rundown of LKLís compliance and disclosure violations as alleged by the SEC:
Financial activities and affiliations. "None of LKLís Forms ADV filed between March 2010 and March 2015 disclosed Loveís affiliated private funds, and each†affirmatively misrepresented that LKL and Love had no outside business activities," the SEC said. It noted that LKL never checked the box required if any of an adviserís related persons serve as a sponsor, general partner, managing member or equivalent of a pooled investment vehicle. Further, the agency said, on Form ADV, Part 2A, the brochure falsely stated that "[t]he firm and its management personnel do not engage in or maintain any financial industry activities or affiliations." While LKLís Part 2B brochure supplement for Love "stated that he maintained an insurance license, [it] then misleadingly stated that Love Ďmay engage in other business activities that are unrelated to the investment industry,í" the SEC said. "This response omitted to state that Love was actively managing private funds, which is an investment industry activity."
Undisclosed interest. The agency also alleged that LKLís Forms ADV "provided false information about Loveís financial interests in client transactions." The adviserís responses "omitted information regarding Loveís private funds and the accompanying financial interests that he had in LKL client transactions," it said.
Assets under management. According to the settlement, Love admitted to SEC examiners that the†advisory firmís AUM on its Forms ADV "was incorrect and inflated," the agency said. "The degree to which LKLís AUM was erroneous varied across the different Forms ADV, but LKL admitted that in certain Forms ADV it overstated its AUM by more than†$30 million," the SEC said. Further, it alleged, while LKL admitted that the amount of the overstatement was a material change (from $130 million to around $101 million), it never properly amended its Form ADV Part 2A brochure, or summary of the material change, to clients within 120 days of the end of the adviserís fiscal year. "Such delivery never occurred despite LKL and Love being informed of the obligation by a compliance consultant," the agency said. If an advisory firm hires a compliance consultant, said Lieberman, "follow its recommendations or document that you disagree with the recommendations and the reasons why."
Refunding advisory fees. The advisory firm, according to the settlement, "falsely stated" in its Part 2A brochure that when its services are terminated prior to the end of a calendar quarter, pro-rated fees would be refunded to the client. "This statement was false because . . . LKL failed to refund a pro rata share of pre-paid advisory fees for multiple client accounts that were closed mid-quarter until after Commission examination staff sent LKL a deficiency letter and Commission enforcement staff started an investigation," the SEC said.
Continuing misrepresentations. "LKLís Form ADV misrepresentations continued even after†Commission examination staff confronted Love about certain affiliated private funds in early 2016," the agency said. While LKL then "belatedly disclosed" that Love served as a managing member of entities meeting the SECís definition of pooled investment vehicles, it "identified only two such funds, . . . and failed to disclose multiple other funds that Love managed and into which certain LKL client money was invested."
The settlement also focuses on Loveís alleged failure to provide records to examiners, beginning with how he "initially represented to Commission examination staff that he had not participated in or had any interest in any other businesses or joint ventures in the past 10 years."
Further, the SEC charged, "when Commission examination staff asked Love about certain funds that [they had] independently identified, Love provided only partial disclosure of the activities of those funds and failed to disclose the existence of other funds that he managed and into which LKL clients had invested money at his recommendation."