Discovery of Fraudulent Registration Offers No Relief from Rule Compliance
One might think that an advisory firm charged with misstating its assets under management in order to register with the SEC could take some solace in believing that it never had to comply with agency rules. After all, such an adviser might think, the Custody Rule, the Books and Records Rule, the Advertising Rule and other rules apply only to SEC registrants. But such an assumption would be a mistake.
One adviser found this out the hard way on April 5. That’s when the SEC reached a settlement with Connecticut-based advisory firm Clayborne Group and its owner, founder and chief compliance officer Dean Heinemann for improperly registering with the agency from 2012 through 2016. In the same settlement, the SEC also charged the advisory firm with violating Rule 206(4)-2, the Custody Rule, and Rule 204-2(a), the Books and Records Rule.
"Because Clayborne was registered with the Commission as an investment adviser, even though it was ineligible to be so registered, it was subject to the Custody Rule," the agency said in its administrative order instituting the settlement.
In other words, even though the adviser was improperly registered, it nonetheless did register, and during that period was therefore subject to the SEC’s rules, said Proskauer partner and former agency Division of Investment Management deputy director Robert Plaze. "It’s like driving on a toll road that you haven’t paid to drive on. If you get a speeding ticket, you can’t tell the police officer, ‘You can’t give me this ticket because I am not allowed to drive on this road.’"
The principle also works in reverse, he said. If an advisory firm should be registered with the SEC but is not, it is still subject to its rules that apply to registered advisers.
Why would an advisory firm that does not qualify for SEC registration want to do so, and thereby subject itself to agency oversight and rules? "A primary reason a smaller advisory firm would want to be registered by the agency may be to avoid having to register with multiple state regulatory agencies," said Tesser Ryan partner Gregory Ryan. "Once a smaller adviser obtains registration with the SEC, the adviser avoids the complex and cumbersome problem of having to deal with multiple sets of regulatory rules and procedures in the states in which they do business. It can be very cumbersome and expensive to an IA to register in multiple states."
In addition, he said, "custodians may also prefer investment managers to be registered with the SEC. These custodians are likely coming under pressure to perform due diligence on the advisers they do business with."
"Falsely inflating assets under management on Form ADV so that an adviser ineligible for registration may appear eligible is particularly dangerous," said Mayer Brown partner Matthew Rossi. "First, the SEC may perceive such a misrepresentation as a fraud on the agency itself. Moreover, when an illegible advisers registers, it unnecessarily subjects itself to a whole range of regulations and potential violations that otherwise would not apply."
The fiduciary tie-in
The settlement may be notable for other reasons, said Stradley Ronon partner Lawrence Stadulis. "The SEC, historically, has rarely brought enforcement actions against advisers for improperly registering under the Advisers Act," he said. "Instead, it simply deregisters them on its own initiative after public notice."
"It is possible," he said, "that the SEC wants to clean house of improperly registered advisers in advance of its likely upcoming uniform fiduciary standard rule proposal (ACA Insight, 1/15/18). If the proposal is adopted, it will further widen the regulatory gap between state and registered advisers. Registration will carry with it an express federal conduct standard, which investors might misconstrue as a regulatory seal of approval. If so, Advisers Act registration may become even more coveted and necessary to successfully conduct business than it is today."
"It is possible that the SEC is concerned about this and is trying to get out the message that it will no longer simply deregister firms," Stadulis said. "After all, improper registration, in and of itself, arguably, is fraudulent to the extent advisers make false and misleading statements about their status to the SEC and the investing public. The practice is certainly at odds with a uniform fiduciary standard."
The firm and its registration
Heinemann formed Clayborne in 2005, and registered it with the Commission in January of that year, through the filing of an initial Form ADV, according to the agency’s administrative order instituting the settlement. At that time, an adviser had to have AUM of at least $25 million to fall under SEC regulation. The settlement order makes no charge that Heinemann and Clayborne did not legitimately pass this marker.
As a result of the Dodd-Frank Act, however, the threshold for SEC registration was raised in July 2012 to $100 million. Clayborne filed a supplemental Form ADV in May of that year, stating that it had AUM of more than $100 million and repeated those representations in subsequent AUMs through 2016, the agency said.
In its Forms ADV filed with the Commission from 2012 through 2016, "Clayborne misrepresented its AUM, because during said period, approximately $100 million of its stated AUM was not continuously and regularly supervised and managed," the SEC said. As a result, during this time period, "Clayborne was ineligible to register with the Commission as an investment adviser because it did not have the requisite AUM, as defined in Form ADV."
A question of custody
Heinemann formed what the settlement order describes as "an investment fund or hedge fund" in April 2010. Managed by Clayborne, the fund conducted a private placement that August and raised $630,000 from seven investors, six of whom were clients of Clayborne, the SEC said.
"Because Clayborne maintained and had access to [the fund’s] client funds, Clayborne had custody of client funds with the meaning of Rule 206(4)-2," the agency said. As such, he "never caused account statements to be provided at least quarterly to [the fund’s] clients for which it maintained funds or securities, as required by the Custody Rule." In addition, he "never caused an examination by an independent public accountant to verify client funds and securities as required under the Custody Rule."
Heinemann, as Clayborne’s CCO, "was responsible for Clayborne’s compliance efforts and knew or should have known that Clayborne failed to provide account statements or to arrange for an annual verification of client funds and securities by an independent public accountant," the agency said.
Books and records
The SEC charged that the adviser "failed to make and keep certain books and records required by Commission rules relating to its investment advisory business."
Violations and punishment
As part of the settlement, the SEC alleged that Clayborne willfully violated Section 203A of the Advisers Act by improperly registering with the Commission, and that Heinemann "willfully aided and abetted and caused Clayborne’s violations." In addition, both Clayborne and Heinemann were charged with willfully violating Section 207, which prohibits the making of untrue statements of material fact in any registration application or report filed with the Commission.
Separately, Clayborne was charged with willfully violating Section 206(4) and its Rules 206(4)-2(a)(3) and (a)(4) for Custody Rule violations, and Section 204(a) and its Rules 204-2(a)(7) and (a)(10) for books and records violations. Heinemann was charged with having willfully aided and abetted, as well as caused, those violations.
Heinemann was suspended from the securities industry for 12 months, and ordered to pay a civil money penalty of $20,000. An attorney representing Clayborne and Heinemann, when reached, chose not to comment.