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News January 29, 2018 Issue

Undisclosed Investment Strategy Changes Unlikely to Save the Day

An adviser may start a fund with high expectations, but find that, for a number of reasons, returns do not come in as expected, and in fact go south. Advisers in such situations may be tempted to turn to a higher risk/higher reward investment strategy in the hope it will make up for the losses. Those that do should be aware that such a move may bring with it business and compliance challenges that no adviser wants to face.

Pennsylvania-based Team Financial Asset Management (TFAM) and Team Financial Managers (TFM), both advisory firms, along with James Dailey, who owned one of the firms and was co-owner of the other, recently settled charges with the SEC. Those charges related to investment strategy changes in TFAM’s only fund, changes that, in the words of the agency, "led to catastrophic losses and the ultimate collapse of the fund."

They also led to the voluntary termination of both advisory firms, an open-ended bar against Dailey working in the securities industry, and the requirement that Dailey pay disgorgement of $65,062, prejudgment interest of $6,277, and a $130,000 civil money penalty. The advisory firms were also both censured. An attorney representing the TFAM, TFM and Dailey did not respond to a voice mail or email seeking comment.

The SEC’s main concern, as indicated in the administrative order instituting the settlement, was not the business losses the new investment strategy appeared to have brought, but that Dailey did not adequately disclose – and in some cases, the agency said, materially misrepresented – those changes to investors, prospective investors or the Board of Trustees of a related investment company.

The SEC focused on a fund Dailey formed in 2009, the TEAM Fund. "In particular, the TEAM Fund’s prospectuses did not disclose the fund’s use of derivatives and short selling as principal investment strategies or the expenses associated with short selling," the agency said. "Additionally, the fund did not adequately disclose the principal risks of investing in the fund caused by these principal investment strategies."

The result of implementing a more aggressive investment strategy for the fund involving "large amounts of derivatives trading for speculative purposes and short selling" was that the fund had losses of 22 percent in fiscal year 2012 and 80 percent in fiscal year 2013, and then liquidated that same year, the agency said.

"This case is one in a long line of SEC enforcement matters alleging a discrepancy between representations to investors and actual practice," said Paul Hastings partner Nicolas Morgan. "Particularly when that alleged discrepancy relates to changes in investment strategies that lead to investor losses, the SEC will be quick to cry foul. Here, significant time passed between the representations describing the investment strategy and the shift to a new strategy, highlighting the need for advisors to review such representations – in private placement memorandums, limited partnership agreements, prospectuses, and elsewhere – over time as circumstances change."

"Mutual funds have risks and sometimes they lose money," said Pepper Hamilton partner John Falco. "It is important to remember that the liability here arose from the inadequate disclosure, not from investment losses sustained by the fund."

"When an adviser contemplates material changes to a fund’s strategy, techniques or risk profile," he said, "there are a number of steps that should be taken – and that appear not to have been taken in this case – before implementation: communicating the changes to the fund’s board and obtaining any board or shareholder approvals if required; supplementing the fund’s prospectus disclosures regarding principal strategies and risks, and communicating the changes to existing shareholders; and collaborating with the fund’s other service providers and compliance functions to make sure controls are in place to monitor compliance with the prospectus."

The change in strategy

Dailey, while working at TFM in 2003 as its portfolio manager, developed an investment strategy that would invest his clients in mutual funds, exchange-traded funds and some individual stocks, according to the agency’s administrative order. The purpose, the SEC said, was "to navigate what Dailey expected to be a 15 to 20-year period of very low stock market returns, particularly in the United States, coupled with a bull market in commodities during the same period."

The strategy apparently worked. The agency said that TFM clients had returns, gross of fees, of approximately 13 percent in 2008 and 2009 – a period when the financial crisis hit particularly hard.

So, in 2009, Dailey apparently decided to use that same strategy in a new mutual fund, the TEAM Fund, which he would start. He "believed that a mutual fund would allow him to effectively implement [the same strategy that he had used at the TFM Fund] through techniques that were not possible or cost effective in TFM’s discretionary, separately managed accounts," the SEC said. Those techniques, the agency said, included short term trading, foreign exchange trading and increased individual stock trading.

Dailey in September 2009 formed a new advisory firm, TFAM, to advise the TEAM Fund. He was TFAM’s owner and managing member, and, according to the SEC, was the fund’s portfolio manager, as well.

The TEAM Fund and compliance

What exactly was the Team Fund? It was set up as an open-end series of the Indianapolis-based Valued Advisers Trust (VAT), which was also a registered investment company. VAT, which offered turnkey investment company services, allowed Dailey to manage the TEAM Fund without having to administer the day-to-day operations of the fund, responsibilities that included corporate governance and regulatory compliance.

"VAT’s fund administrator, as well as the VAT Board, provide compliance oversight for advisers managing mutual funds on VAT’s platform, but each adviser is required to maintain its own compliance programs," the SEC said. What did this mean in practice? "VAT’s policies and procedures required advisers (like TFAM) to maintain policies and procedures describing, among other things, the risk management and internal controls implemented to monitor and control for derivatives related risks, the process for assessing risks and ensuring that controls are commensurate with the risks, and the implementation of procedures addressing risks associated with derivatives trading," the agency said.

But since Dailey, according to the SEC, did not provide any derivatives policies and procedures to the TEAM Fund and the VAT Board for adoption and implementation, "VAT and the Team Fund failed to adopt and implement policies and procedures regarding derivatives.

Derivatives, futures, options and more

"Towards the end of 2011, Dailey decided that, based on his forecasted increase in market volatility, including the probability of a recession and a more moderate cyclical bear market in stocks, coupled with the relative spread in returns between stocks and commodities, he would invest the TEAM Fund more heavily in derivatives (including for speculative purposes) to continue to successfully implement his global macro strategy," the SEC said.

The administrative order notes that Dailey "began trading extensively in futures and options while continuing to trade in forward currency contracts," the agency said. For instance:

  • During the 2012 fiscal second quarter, which ended on April 12, 2012, "Dailey invested 73.8 percent of the fund’s net asset value, based on notional exposure, in futures and options as of the end of the quarter."
  • Through October 2012, "Dailey’s use of derivatives further increased, and represented an average of 103.93 percent of the TEAM Fund’s NAV.

Prior to April 2012, "Dailey’s use of derivatives had been limited to options and forward currency contracts, and was never more than 11.68 percent of the NAV," the SEC said. "This increase in the aggregate derivatives’ exposure significantly increased the risk profile of the fund."

The agency said that Daily then "continued to increase the TEAM Fund’s use of options throughout 2013, even as the market value of the portfolio continued to decline." During the first three quarters of fiscal year 2013, for instance, "Dailey was spending approximately 29.5 percent of the TEAM Fund’s NAV on quarterly basis on premiums [emphasis SEC] to purchase options."

Dailey also began selling short equity securities "in massive amounts" during the fourth quarter of 2012.

Here, according to the SEC, were the results of this change in investment strategy:

  • The TEAM Fund lost approximately 22 percent in fiscal year 2012. "Of the $16.6 million lost in net assets, $10.5 million or 63 percent was due to derivatives trading."
  • The TEAM Fund lost approximately 80 percent in fiscal year 2013, "plummeting from approximately $60 million in net assets to only $4.8 million." The agency said that approximately $20.5 million of the decrease resulted from shareholder redemptions and approximately $34.67 million resulted from investment losses. "Of the $34.67 million loss, $24.9 million or 72 percent was due to derivatives trading."

 What’s more, the agency alleged, Dailey used his discretionary authority at TFM to keep the separately managed clients there invested in the TEAM Fund throughout 2012 and 2013, despite the fund’s "deteriorating performance." Dailey, the SEC said, "kept TFM’s clients invested in the fund even as it decreased in value and other investors were pulling their investments in order to attempt to realize economies of scale to minimize fund expenses."

Lack of disclosure

The SEC, it is sometimes said, is often a disclosure regime. It was in this regard that the agency’s case resulted in fraud charges. Specifically, it alleged that:

  • Dailey did not adequately inform the Board. Despite having sought permission from the VAT Board of Trustees in December 2011 to revise the investment strategies and risk disclosures in the TEAM Fund’s registration statement, "Dailey did not fully disclose that derivatives trading was a principal investment strategy, nor did he disclose the significant risks of this trading," the SEC said. "Moreover, he never disclosed his intention to engage in significant short selling. . . . As a result of these failures, Dailey did not adequately inform the Board of material changes to the TEAM Fund’s primary investment strategies and the significant impact of these changes on the primary risks of investing in the fund."
  • Prospectuses contained material misstatements and omissions. "The 2012 and 2013 prospectuses did not fully disclose the TEAM Fund’s use of derivatives as a principal investment strategy," the agency said. Nor, it said, did those prospectuses disclose that the TEAM Fund would be selling securities short. "Because of the more aggressive investment strategy adopted by Dailey in the TEAM Fund beginning in February 2012, the investment strategies and policies of the discretionary advisory accounts were no longer ‘substantially similar’ to those of the TEAM Fund."
  • Annual report contained material misstatements and omissions. Form N-CSR, which was prepared by TFAM for the TEAM Fund and filed in January 2013, "did not adequately discuss the fund’s derivatives trading and short selling," the agency said. "The TEAM Fund failed to fully disclose its investment strategy and its use of derivatives trading and short selling in the annual report, which was drafted by Dailey."
  • Forms ADV contained misstatements and omissions. Over the course of four Form ADV annual filings from March 2010 through February 2013, TFAM allegedly did not adequately address the changes in its investment strategy. For instance, in the "Risk of Loss" subsection in the brochure portion of each Form ADV, the description in the 2012 and 2013 Forms are "identical" to the 2011 Form ADV, the agency said.

"A robust compliance program should monitor the fund’s portfolio positions against the prospectus and periodically ask the adviser about new types of investments being used," said Falco. "Those procedures could have prompted fund management and compliance personnel that the disclosure needed to be updated, and that additional policies and controls would need to be applied to the fund."