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News September 17, 2018 Issue

Failure to Disclose All Redemption Options May Lead to Enforcement Action

It may be tempting to be nice when an investor wants to cash in part of his or her investment with shorter notice window than your firm usually allows. But a shorter redemption window for some investors may lead to unfair results for other investors forced to wait – especially if all redemption options have not been disclosed.

Former private fund investment adviser Aria Partners ran into just this kind of problem, according to the SEC’s recent settlement with the adviser, which used to be based in both Boston and Los Angeles. The adviser was censured and had to pay a $150,000 fine after the agency found it in violation of several sections of the Advisers Act because it failed to disclose to all investors in one of its funds all their options to redeem their investments.

“The fund’s limited partnership agreement required 90 days’ written notice for redemptions,” the SEC said in its administrative order instituting the settlement. “However, respondent had an informal policy, which was not disclosed to all investors in the fund, of accommodating investors’ requests to give partial redemptions on significantly less notice than 90 days.”

Further, the agency said, Aria “granted full redemptions to a limited number of investors on 60 days’ notice, while similarly situated investors were held to the 90 day notice period. These practices resulted in materially different full redemption amounts for two investors in 2015, when the fund lost value in a short period.”

The SEC blamed the problem on what it said was the adviser’s failure to implement a compliance program consistent with its obligations as a registered adviser. In the case of Aria, it said, the compliance failures also resulted in other violations, among them Rule 206(4)-2, the Custody Rule, inaccurate statements concerning assets under management and private fund clients in Form ADV, and the firm renewing its registration with the SEC when the advisory firm no longer had the assets to qualify. An attorney representing the firm did not respond to an email or voice mail seeking comment.

“This is one of the cardinal sins – favoring one client over another,” said Lowenstein Sandler partner Benjamin Kozinn. “The governing documents are there for a reason.”

“Normally, a fund’s private placement memorandum and subscription documents describe in detail the redemption process, including how the redemption amount is calculated and proceeds returned, and specifying the timing of the valuation and the payment,” said Perkins Coie partner Alexandra Alberstadt. “These sections would normally include a disclosure that the manager has discretion to waive deadlines. It seems that disclosure may have been absent in this case.”

Such documents, she said, “typically include a statement that they are the governing documents for the fund, so a secretary’s subsequent statement should not have been treated as establishing a new redemption timing rule. If, however, as the SEC alleges, the manager had a regular practice of waiving the deadlines for redemption requests, the manager should have disclosed that practice in its communications to investors.”

Formal and informal policy

Both the fund’s LPA and its marketing material required at least 90 days’ written notice for redemptions from the fund, according to the settlement order. Aria, however, also had an informal policy, “for at least a decade as of 2015,” that allowed investors to make a partial redemption upon request with less than 90 days’ notice, the SEC said. “The informal redemption policy was never reflected in Aria Partners’ written policies and procedures, and [Aria Partners] never broadly communicated the policy to all fund investors.”

As for full redemption requests, the agency said that, during 2015, “a new Aria Partners administrative employee mistakenly informed several investors who requested full redemptions that they could receive a redemption upon 60 days’ notice.” What happened, the SEC said, was that the administrative employee “confused the 90 day redemption terms of one of [the adviser’s] private funds with another private fund that permitted redemptions on 60 days’ written notice.”

Underlying it all, according to the settlement order, was that Aria did not have written policies and procedures to help employees correctly communicate redemption terms to all fund investors. “As a result,” it said, “in 2015, when two consumer fund investors sought full redemptions at approximately the same time, one investor was redeemed on 60 days’ written notice and another investor was redeemed on 90 days’ written notice.” The result? “After the redemptions were requested, the fund declined in value, which had the unintended effect of the investor who was redeemed on 90 days’ notice receiving significantly less than it would have received on 60 days’ notice.”

The advisory firm did have a compliance manual and procedures, the SEC acknowledged. They were adopted, however, in 2004, and “were not tailored to the type of business [Aria Partners] conducted.” Further, according to the settlement order, the adviser “did not update the manual as its business changed,” nor did it conduct its own annual review. Aria “mistakenly relied on third parties, including a fund administrator and fund auditor, to raise any issues concerning the adequacy of Aria’s compliance policies and procedures.”

Other problems

The SEC charged that the firm’s problems with its written policies and procedures caused other problems, as well. Specifically:

  • Custody Rule violations. Rule 206(4)-2 requires, among other things, that advisers with custody of client funds or securities have independent public accountants conduct an annual surprise examination or audit of client assets. Aria, however, “did not complete annual audits (or do an annual surprise examination) for the fiscal years ending December 31, 2015 and December 31, 2016,” the SEC said. “[It] chose not to conduct audits for those two years because the funds had been materially wound down and the asset values at year end were almost zero.”
  • Form ADV violations. The Forms ADV Part I filed by Aria in March 2015 and October 2015, as well as the Form ADV Part 2A filed in March 2015, “contained omissions and inaccuracies,” the agency said. Aria allegedly did not update its regulatory AUM, “which at the time were significantly below the requirements to register as an investment adviser with the SEC,” the agency said. The firm also allegedly did not identify itself as an adviser to private funds.