Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News September 24, 2018 Issue

Don’t Promise One Investment Strategy to Investors and Use Another

Investors might justifiably be somewhat upset if they find out that the fund in which they invested had to shut down. They might be even more bothered if they discover that the adviser managing the fund invested their dollars using a higher risk investment strategy than promised – and so might the SEC.

The 10 investors who collectively placed about $2.2 million from at least June 2014 through August 2015 in a private fund managed by Santa Barbara, California-based Biltmore Wealth Management and its owner/portfolio manager Caleb Overton might have reason to complain. The SEC, in a recent settlement, alleged that Biltmore and Overton with misleading the fund and the investors by claiming that the fund “would invest primarily in leading growth stocks, but instead caused the fund to make substantial trades in risky stock options.”

The fund lost nearly all its value in August 2015 and was dissolved in November 2015, the SEC said.

The investors do not appear to have been sophisticated. According to the settlement order, of the 10 investors, eight of whom had pre-existing advisory relationships with Biltmore, seven were 60 years old or older, six invested funds from their retirement savings, and four were unaccredited. During the same period, Biltmore earned at least $22,580 in fees, the agency said.

“The high-risk nature of the fund’s options trading was not theoretical,” the SEC said. Over four trading days in August 2015, it said, a series of options trades placed by Biltmore and Overton generated losses that “decimated” the fund. “The fund lost 98 percent of its value, leaving it with approximately $34,000 by the end of August 2015.”

“This settlement is an object lesson to investment advisers that you need to do what you say you are going to do, whether that relates to investment strategies, operational systems or compliance policies,” said Faegre Baker Daniels partner Jeffrey Blumberg. “The SEC expects, and reasonably so, that if a firm affirmatively states that it will follow some stated mode of behavior, failing to do so is inherently a breach of the firm’s fiduciary duty to its clients. It is akin to agreeing to be at work each day by 8:00 a.m. – if you fail to arrive at work by 8:00 a.m. on a consistent basis, your employer will terminate your employment because you are not living up to the terms of the deal you made.”

“The SEC’s Division of Enforcement has long warned investment advisers against misrepresenting fund investment strategies, risk profiles and the source of returns, particularly losses,” said Mayer Brown partner Matthew Rossi. “Although investment strategy can be described in a manner that provides an adviser with broad flexibility, in this case it appears that the SEC concluded the adviser omitted a category of high risk investments that it knew from the beginning would be part of the fund’s strategy. With the creation the SEC’s Retail Strategy Task Force, the Enforcement Division will be particularly vigilant when these types of violations impact retail investors as appears to have been the case here.”

Ropes & Gray partner Jason Brown said that the settlement “shows the importance of reviewing your disclosures carefully and making sure that you have a process in place to monitor compliance.”

Violations and sanctions

As part of the settlement, Biltmore and Overton were found to have willfully violated Sections 206(1) and (2) of the Advisers Act, both of which prohibit fraud. In addition, they were found to have violated Section 206(4) and its Rule 206(4)-8, which prohibits an adviser from making untrue statement of material fact or omitting to state a material fact.

Biltmore was censured, while Overton was barred from the securities industry for five years. In addition, both were ordered to collectively pay disgorgement of more than $23,000, plus prejudgment interest of $2,599, as well as a civil money penalty of $160,000. An attorney represent the two did not respond to a voice mail or email seeking comment.

Investment strategy and prospective investors

The “substantial trades in risky stock options” that the SEC mentioned included options on the SPDR S&P 500 ETF, which it said attempts to replicate the return of the S&P 500, and which it refers to in the settlement order as the “SPY options.” In addition, the agency said, “Biltmore and Overton . . . misrepresented to investors that the fund’s risk would be mitigated by ‘stops’ that would limit its losses to just 7 to 8 percent, but fund’s losses often exceeded those limits.”

These alleged misrepresentations occurred in a number of ways, the SEC said, including the following:

  • Private placement memorandum and subscription agreement. “The PPM described the fund’s investment objective as that was designed to ‘achieve significant returns for investors in all market conditions and with relatively low correlation to broader market indices,” the agency said, and that “the fund’s investment strategy was to ‘invest in a concentrated long/short portfolio of leading growth companies. We actively buy fundamentally superior stocks that are breaking out technically. We look to lock in gains in the 20 to 25 percent range and limit our losses to 7 to 8 percent through the use of stops. We are aiming to have a 3 to 1 profit loss ratio.’” What the PPM did not state, the SEC said, was that the use of options would be part of the fund’s investment strategy. Options trading, according to the agency, was mentioned only as one of many risk factors.
  • Oral presentations. The SEC pointed to oral presentations that Overton made in face-to-face meetings with prospective investors, including his use of PowerPoint. In these sessions, “he emphasized the fund’s focus on identifying and investing in superior growth stocks and did not discuss the significant role option trading would have in the fund’s investment strategy.” Once these prospects actually invested, the investors received monthly letters from Biltmore that were written by Overton, the agency said. As for the PowerPoint presentation itself, the SEC said that it made similar statements, among them that the fund would limit its losses to 7 to 8 percent, and that its portfolio construction would be “max 150 percent long (individual stocks)” and “max 100 percent short (short indexes and individual stocks).” “The PowerPoint presentation did not reference options, let alone SPY options.”


“Over the course of 11 months from the fund’s inception in October 2014 until it suffered catastrophic losses in August 2015, the fund lost $1.89 million,” the settlement order states. “For four of the 11 months of its existence, the fund’s losses or profits resulted exclusively from options trading, and for the other months the percentage of the fund’s net profit or loss due to options trading ranged from more than 40 percent to 95 percent of the fund’s total losses. On a net basis, for the entire 11-month period, the fund’s $1.89 million loss is attributed entirely to the options trading, with the vast majority of that loss coming from trading in SPY options.”

But the depth of the problem created by the investment strategy apparently went deeper. “Not only was the fund unprofitable from the extensive options trading during the course of its existence, the fund’s risk profile was dramatically higher than disclosed to investors,” the SEC said. “Because options can expire worthless, the entire amount of the options investments was at risk every time Biltmore made such an investment.”

Further, because of the fund’s significant options trading, the fund was in violation of its representation that its use of leverage would not exceed 130 percent of the fund’s net asset value, the agency alleged. “In fact, Biltmore’s average option-adjusted long leverage position was 614 percent of NAV, and Biltmore exceeded the disclosed 130 percent limitation on 79 percent of the days it was in operation.”