Concealing Asset Values Won’t Solve Problems, May Bring SEC Charges
No adviser wants to see declines in the asset values of the client accounts they manage. Concealing those declines from clients and regulators, however, is not the answer. Not only will clients find out and likely be quite upset, but there is a good possibility the SEC’s Division of Enforcement will take notice. Better to come clean about the true state of affairs.
Two advisory firms, New York City-based Blue Alternative Asset Management, and San Juan-based Blue Capital Management, along with their owner, Mark Graham, on September 6 settled charges with the SEC that, from September 2015 through at least December 2017, they “engaged in a complex scheme to conceal declining asset values in various client accounts,” the agency said. The firms, both of which are no longer registered with the Commission, and Graham collectively agreed to pay more than $2.5 million in disgorgement, prejudgment interest and fines, according to the settlement order.
The concealment attempts by the two firms, referred to jointly in the order as the “Blue Advisers,” and Graham allegedly included making false statements and improperly redeeming investments from private funds that they controlled. “The Blue Advisers’ and Graham’s active concealment contributed to large losses by one trust client, bringing the insurance company beneficiary of the trust to the brink of collapse,” the SEC said.
The facts presented by the agency in the settlement order paint a picture of complex financial transactions, but in the end the alleged attempts to conceal the decline in asset values did not work. Two insurance company beneficiaries found out and eventually collected arbitration awards from a Cayman Islands-based reinsurance company, Alpha Re, controlled and majority-owned by Graham, and, of course, the SEC ultimately discovered the situation and took action.
“This case is about the exercise of poor judgment – the poor judgment of the adviser in allegedly hiding declining asset values from investors, but more importantly, the poor judgment of the adviser in failing to consult with counsel before acting on the impulse to conceal,” said Paul Hastings partner John Nowak. “The case also highlights the SEC’s continued focus on valuation issues and the importance of involving a third party auditor or valuation vendor to act as a check and balance in the valuation of complex assets.”
“Many of the conflicts were baked in from the beginning, in that Graham had a majority ownership in Alpha Re, and the firm had advisory relationships with a number of the parties involved,” said Proskauer partner Samuel Waldon. “It was a recipe for disaster.”
One takeaway from this settlement is the importance of disclosure and compliance policies, said Foley & Lardner partner Jessica Matelis. “It’s important to disclose both the risks and the investments themselves, along with having sufficient controls in place to avoid misleading investors. The SEC is very focused on conflicts, as well as whether investors have complete information.”
The parties and the investments
Aside from the Blue Advisers, Graham and Alpha Re, among the other entities involved in this matter was a United States trust, Cygnet 001 Master Trust, with different series, one called Series 2011-C and another called Series 2013-A. The Blue Advisers were the collateral managers for the trust.
“Between 2011 and 2013, Alpha Re entered into reinsurance contracts with several U.S.-based life insurance companies,” the agency said. These included a $153 million contract in 2012 with an insurance company identified by the SEC as “Insurance Company A,” and a $103 million contract in 2013 with an insurance company identified by the agency as “Insurance Company B.” Alpha Re established reinsurance trusts for each insurance company, with each insurance company being the beneficiary of its respective trust.
“In each case,” according to the settlement order, “Alpha Re assumed a portion of each company’s insurance liabilities in exchange for an insurance premium, and was responsible for making payments to the insurance companies on a monthly basis to pay for insurance claims.”
Graham, as Alpha Re’s majority owner, “was directly impacted by whether Alpha Re made or lost money on investments made by the reinsurance trusts,” the SEC said. The Blue Advisers and Graham also received management fees as a result of investing the reinsurance trust assets into other funds and investments that they advised and controlled.
The settlement order describes a number of complicated investments made by the reinsurance trusts, with Cygnet Trust acting as a securitization vehicle for the trust assets. The investments then made on behalf of Cygnet Trust’s Series 2011-C included hedge funds managed by Graham, a leveraged swap, a Cygnet Trust Series 2013-A share certificate, and several private funds.
“By at least September 2015, Series 2011-C’s assets had declined substantially in value,” the SEC said. “This decline in asset values continued through 2016 and into 2017. The decline in Series 2011-C’s assets led to a corresponding asset shortfall in the Insurance Company A Reinsurance Trust and the Insurance Company B Reinsurance Trust because Series 2011-C’s assets were being used to support the Insurance Company A’s repos and the Insurance Company B’s complex investments.”
Concealing the assets
“Rather than disclose the asset shortfalls to the reinsurance trusts (which would have required Alpha Re to contribute additional assets to make up for the asset shortfalls and could have caused the insurance companies to withdraw assets from their respective reinsurance trust), the respondents engaged in a scheme to defraud Insurance Company A Reinsurance Trust and Insurance Company B Reinsurance Trust,” the agency said.
Blue Advisers and Graham, according to the settlement order, did the following:
- Made false statements to the trustees of the two reinsurance trusts as to the value of the securities that supported 2015 and 2016 repurchase agreements that they allegedly caused both Insurance Company A and Cygna Trust to enter into,
- Failed to disclose a reduction in the value of the reinsurance trust assets,
- Improperly redeemed investments from private funds that the respondents controlled to provide liquidity to Series 2011-C, and
- Engaged in other deceptive conduct, including Graham “knowingly and repeatedly misrepresent[ing] to representatives of Insurance Company A that sufficient collateral for the repurchase agreements existed and that they were fully collateralized,” and that Graham “made numerous misrepresentations to Blue Capital Management’s chief compliance officer.”
Both insurance companies eventually found themselves in arbitration with Alpha Re. Company A, which “was privately held until January 2018, when it was forced to sell the entire company to another insurance company to raise capital to fund its reserves,” according to the settlement order, received an initial arbitration award in late 2017 requiring Alpha Re to pay its reinsurance trust more than $100 million in assets.
Insurance Company B found itself in arbitration with Alpha Re in late 2016, the agency said. As part of a settlement reached in March 2017, Alpha Re received $64 million from the Cygnet Trust.
As for Alpha Re, the Cayman Islands Monetary Authority in January 2018 issued a cease-and-desist order against it, thereby preventing it from writing any further business, according to the settlement order. The day after this order was issued, the SEC said, Alpha Re went into voluntary liquidation.
As part of the settlement, both the Blue Advisers and Graham were found to have willfully violated Sections 206(1) and (2) of the Advisers Act, which prohibit fraud. In addition, they were found to have willfully violated Sections 206(4) and its Rule 206(4)-8, which prohibits advisers from making untrue statements of material fact or omitting to state a material fact.
Blue Capital Management and Graham were found to have willfully violated Blue Capital Management’s violations of Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule. The Rule requires advisory firms to adopt and implement reasonably designed written compliance policies and procedures. Finally, these same two parties were found to have willfully violated Section 207, which makes it illegal to make an untrue statement of material fact in any registration application or report filed with the SEC. An attorney representing all three parties did not respond to a voice mail or email seeking comment.