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News February 5, 2018 Issue

Fund Administrators that Fail to Act on Red Flags May Face Charges

Fund administrators should be under no illusion that if a fund runs into trouble, the administrator is somehow immune because it is not the fund, but simply provides services to it. Administrators have an obligation to watch for and act on red flags, particularly those that involve client assets.

Nebraska-based Gemini Fund Services, a full service mutual fund administrator, on January 22 settled charges with the SEC that it failed to act on knowledge that the custodian bank of a fund it was providing administrative services for did not have adequate proof of the existence of certain "fake assets" and failed to act on that knowledge.

"When confronted with this fact, Gemini failed to take any further steps, such as further investigating the problem with the assets, notifying the investing public or the board of directors of [the fund] that the custodian bank did not have proof of the validity of the assets, or reducing the share price to reflect the problem," the SEC said in its administrative order instituting the settlement.

"The SEC has occasionally brought cases against fund administrators in connection with frauds allegedly perpetrated by fund managers," said Shartsis Friese partner Jahan Raissi. "What is noteworthy in this and the other cases is that the SEC is not alleging that the†administrator knew that there was fraud. Rather, the SEC is claiming that the administrator failed to follow up on discrepancies or red flags that, if properly inquired into, might have uncovered the fraud."

"The settlement is a reminder for all Ďgatekeeperí service providers to advisers that the SEC can bring what are essentially professional negligence claims against them through the use of its power to charge gatekeepers with Ďcausingí the adviserís violation," he said.

The agencyís action, said Paul Hastings partner Thomas Zaccaro, "demonstrates the high standards to which the SEC will hold those persons and entities that provide services to funds in order to protect retail investors, a priority which SEC chairman Jay Clayton has repeatedly emphasized during his tenure."

Context

The settlement is the latest development in a larger case involving Daniel Thibeault, former managing director of advisory firm Massachusetts-based GL Capital Partners. Thibeault, in February 2013, allegedly began stealing money from investors in one of his firmís funds (the GL Beyond Income Fund the GL Fund), which held mostly unsecured consumer loans. Thibeault did this, the SEC said, by creating fictitious loans originated through a special purpose entity he created. He "used the names and personal information of friends and associates without their knowledge or permission to serve as the purported borrowers for the . . . loans, and thus caused GL Fundís custodian bank to wire out investor funds for these purported loans. Thibeault then diverted those investor funds . . . to his personal and business bank accounts."

Thibeault was caught and in December 2014 charged with criminal securities fraud by the U.S. Attorneyís Office for the District of Massachusetts, pled guilty to one count of securities fraud and one count of obstruction of justice, sentenced to nine years in prison and ordered to pay more than $15.3 million in restitution. Further, the SEC in January 2015 filed a civil complaint against Thibeault and his firm, resulting in a September 2016 judgment against him (ACA Insight, 1/19/15).

Now, with the SECís settlement with Gemini Fund Services, one of the peripheral players in the matter, the agency appears to be reinforcing the message that those it believes helped fraud along, even if not the main perpetrators, will face action.

The Gemini case

Gemini performed a variety of services for the GL Fund, including serving as the fund administrator, fund†accountant and transfer agent from January 2012 to December 2014, according to the administrative order.

Among the activities that a third-party administrator, like Gemini, might perform is the calculation of a fundís daily net asset value, the SEC said. In addition, a fund administrator might also perform a reconciliation of the fundís internal records with the records of a third-party custodian, such as a custodian bank. "Reconciliation between a fundís data and a fund custodianís records is an important administrative controls process that is intended, among other things, to reduce fraud and error in calculation of a fundís NAV," the agency said.

Gemini, as part of its agreement to administer the GL Fund, struck a per-share NAV for the fund daily, and then transmitted that NAV to the NASDAQ securities exchange, the SEC said. In addition, according to the administrative order, it received daily transaction data from the GL Fundís adviser and ran a daily reconciliation report comparing its records of the GL Fundís assets to daily account holdings reports from the GL Fundís custodian bank.

Therein lays the problem. "From February 2013 through December 2014, Gemini struck an inflated NAV for the GL Fund and transmitted that inflated NAV to the NASDAQ securities exchange," the SEC said. "Based on the information it received from GL Capital, the GL Fundís adviser, and/or from GL Capitalís affiliated loan servicer, Gemini included the fake . . . loans as assets of the GL Fund when striking the GL Fundís NAV."

"In reality," the agency said, "GL Capital had caused the fake . . . loans to be generated and then misappropriated the proceeds of those loans when they were disbursed from the GL Fundís custodian bank."

Gemini did not know that the loans were fake, the SEC said, "Gemini personnel did know Ė through their performance of the contractually required reconciliation process with the GL Fundís custodian bank Ė that for extended periods of time the GL Fundís custodian bank did not have adequate proof of the existence of the . . . loans. Gemini knew that the custodian bank was therefore counting the . . . loans as assets of the GL Fund during the same time that Gemini was striking a NAV that did [emphasis SEC] include those same assets."

This was not a one-time occurrence, according to the administrative order. During the relevant time period, the fund administrator "continued to include those†. . . loans in calculating the NAV for the GL Fund, even though Gemini personnel knew that the GL Fundís claimed assets exceeded, by as much as $6.8 million, the assets reflected in the custodian bankís records of the GL Fundís holdings," the agency said.

This continued throughout 2013 with each loan Ė there were 22 such loans created by Thibeault in the fiscal year ending January 31, 2014, the SEC said Ė "and the discrepancy between the GL Fundís adviser data and the custodian bankís records grew larger," the agency said. "The custodian bank explicitly informed Gemini that the custodian bank could not book these loans as assets of the GL Fund because the adviser had not yet provided the custodian bank with the underlying loan documents. Nevertheless, Gemini continued to include these undocumented (and, as it turned out, fraudulent) loans in striking the GL Fundís daily per-share NAV."

Gemini personnel throughout 2014 came to be aware of new reconciliation discrepancies between the custodian bankís records and the information received from the GL Fund adviser, according to the administrative order. Thibeault generated 18 more fraudulent loans†between February 2014 and December 2014, with four of them booked as GL Fund assets by the custodian bank, the SEC said. The fund administrator continued to include the loans in striking the NAV until Thibeault was arrested in December 2014, "ultimately transmitting a daily NAV to NASDAQ that at its peak was inflated by at least $15 million in fraudulent . . . loans, of which several million was not reflected as assets of the GL Fund by the custodian bank during the same time period."

During this period, as before, the agency said, "Gemini did not report the non-reconciling asset values to the GL Fundís board or to the investing public."

Violations and remedial action

Gemini was charged with causing Thibeaultís and GL Capitalís violations of Sections 206(1) and (2) of the Advisers Act, both of which prohibit fraud.

The fund administrator was ordered, as part of the settlement, to hire an independent compliance consultant, who, among other things, will be required to conduct a comprehensive review of, and recommend corrective measures concerning, Geminiís compliance and other policies and procedures in regard to NAV calculation and publication, reconciliation of data with fund custodians, monitoring of the performance of administrative and professional services provided to mutual fund clients by other service providers, coordination of financial audits, and detecting and addressing fraud.

Gemini also agreed to pay disgorgement and prejudgment interest of approximately $161,000, and a civil money penalty of $400,000. An attorney representing the firm, when reached, chose not to comment.