Full Disclosure Needed When Advisers Raise Money to Keep Themselves Afloat
Desperate times may call for desperate measures – but not measures so desperate that investors are kept in the dark about key elements and the SEC takes notice. This is especially true when the party seeking to raise money for itself is an investment advisory firm, and the parties from which it seeks to raise those dollars include its own advisory clients.
The SEC on January 23 settled charges with an advisory firm, California-based AmericaFirst Capital Management, and two of its executives regarding the adviser’s attempts to borrow money for itself from investors, including its own clients, without what the agency considers full and proper disclosure. AmericaFirst, according to the SEC’s administrative order instituting the settlement, was experiencing significant financial problems, including increasingly negative net worth and decreasing net income.
"As of December 2012, AFCM was struggling financially because its ongoing business expenses (approximately $2.3 million) exceeded the amount of money it generated from advisory fees (approximately $1.4 million)," the SEC said.
AFCM, registered with the Commission as an adviser since May 2007, was the investment adviser to five mutual funds with approximately $150 million in assets under management from individual investors, and to more than 25 individual retail clients, with approximately $4 million in AUM. For its advisory services, AFCM charged both sets of clients fees of between 1 percent and 1.95 percent of AUM.
"The SEC is almost certain to closely scrutinize transactions where a registered investment adviser is raising money from its own advisory clients, as was the case here," said King & Spalding partner Alec Koch. "It’s especially important in such a situation to make sure that disclosures to potential investors are complete and accurate."
"This case shows the tricky conflicts that advisers can fall into if they expand the advisory client relationship beyond a straight financial planning and investment management relationship," said Pasquarello Fink partner William Haddad. "It is often simply not worth the potential headache and reputational harm associated with going beyond the essential advisory relationship, even with the best of intentions."
"The Investment Advisers Act of 1940 prohibits investment advisers from committing acts of fraud or deceit on current or prospective clients," noted Stark & Stark attorney Max Schatzow. "It is a dangerous proposition for an investment adviser to accept a loan from a client or prospective client or to allow a client or prospective client to make an investment in the firm. The stakes are raised when the investment adviser is experiencing financial trouble. The fact that retail clients were involved, as opposed to sophisticated institutional clients, made this case that much more likely to end up in the enforcement process."
AFCM, in a statement, said that "nothing in this settlement involved our day-to-day advisory activities and nothing in this settlement affects what we believe we have been successfully doing for many, many years – managing mutual funds and separately managed accounts. We had a firm belief throughout our dealings with the SEC that our noteholders received relevant information about our financial affairs but that efforts at documenting what information we sent to noteholders was at times lacking; our records on that score were incomplete. All of our noteholders are sophisticated, none of them have been unhappy with the interest we have paid – always current and above market rates - and the SEC had no complaints from any of our noteholders."
"Since the time frame discussed in the settlement," the statement continued, "we have replaced our head of compliance with an experienced, competent, no nonsense person who will implement the undertakings the firm agreed to in the settlement and provide us with sound guidance in our future operations."
Raising the money and disclosure
AFCM wanted to bridge the gap between its income and expenses, as well as for additional costs related to growing the business. The firm’s founder and chief executive officer, Allan Gonsalves, who owned approximately 38 percent of the firm, made the decision that AFCM should raise the money itself – by issuing unsecured promissory notes with maturity dates ranging from nine to 12 months, the SEC said. "Gonsalves decided that AFCM would target individual retail investors because he perceived these investors to be the easiest way to raise cash. Moreover, to attract investments, Gonsalves set the interest rate at 12 percent, well above the prevailing bond market rates."
Beginning in December 2012 and continuing through December 2015, Gonsalves authorized Robert Lee Clark, AFCM’s president and chief operating officer, "to solicit friends, family members, and AFCM’s advisory clients to invest in new promissory notes and to renew any pre-existing AFCM promissory notes at maturity."
What did Clark reportedly tell these potential investors? According to the summary of the settlement contained in the SEC’s administrative order, Clark "gave the impression" to investors that AFCM was a profitable business and failed to disclose that there was a risk of default associated with the promissory notes.
Later in the administrative order, however, the SEC said that Clark, after contacting prospective investors through telephone calls and in-person meetings, "stated to some investors, and otherwise led others to believe" that AFCM was profitable and that the promissory notes would provide predictable monthly interest income at a high interest rate."
The SEC noted that, in addition to the problems it found in how Clark represented AFCM’s financial condition to prospective investors, the documents that the advisory firm provided to potential investors at the time of investment or renewal "did not fully disclose . . . the degree of risk they faced in purchasing or renewing AFCM’s promissory notes." Those documents include a pro forma letter signed by Gonsalves; the promissory note agreement, which mentioned the interest rate and maturity date, as well as that the cash raised would be used for the advisory firm’s business expenses; and AFCM’s Form ADV brochure.
The documents did not, however, include financial statements. Although the agency said that Gonsalves assumed that his staff would provide financial statements to investors, "he did not follow up to ensure that this disclosure happened. Accordingly, several investors purchased or renewed their promissory notes without the benefit of this information, and invested based on the high interest rate and purportedly stable monthly interest income, and with the expectation that they would receive their full principal at maturity."
While financial statements were not made available, however, "Gonsalves and Clark were aware of the fact that AFCM likely would not be able to repay their notes when due unless they raised cash on hand in the short term, or increased their assets under management in the long term," the SEC said. "In fact, they considered the promissory notes to be similar to non-investment grade bonds (i.e., high risk junk bonds)."
Gonsalves and Clark did have access to the financial statements and, based on their review of them, "each knew that the firm’s cash balance was often negative, and that its revenues were insufficient to cover its yearly business expenses, which contrasted with the more favorable impression that investors had of AFCM’s financial health," the agency said. "Indeed, Gonsalves and Clark did not disclose to investors AFCM’s full financial picture, including the risks of default and liquidity associated with the promissory notes."
Despite all this, the SEC said, Gonsalves and Clark succeeded in raising $1.4 million in AFCM promissory notes and renewing an additional $1.3 million in pre-existing promissory notes from 21 individual retail investors – 14 of whom were advisory firm clients. Further, based on AFCM’s efforts to encourage investors to renew for two years or longer, the adviser holds a promissory note balance of more than $2 million, "even though its plan to increase its assets under management has not been successful."
The above aside, this point stands out: "Thus far, AFCM has remained in operation, and has been able to make timely interest payments to noteholders as well as all requested redemptions of notes," the agency said.
So, one might ask, if AFCM has made good on its payment and redemption obligations, where is the harm? The harm, according to the SEC, was in the advisory firm’s alleged failure to disclose all relevant financial information about itself, including its financial problems, to investors and potential investors, many of whom were its advisory clients.
"It’s interesting that the case only involved negligence-based charges and that the settled order noted that the firm had thus far been able to make payments on the promissory notes," said Koch. "This suggests that the SEC viewed the case as a situation where the defendants should have been more careful and done a better job, but were not engaging in an intentional fraud."