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Investment Management Legal and Regulatory Update - January 2014

January 21, 2014
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Federal Agencies Finalize the Volcker Rule

Five financial regulatory agencies adopted final rules implementing a provision of the Dodd-Frank Act, commonly referred to as the Volcker Rule. The final rules generally prohibit banking entities from:

  • engaging in short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for their own account; and
  • owning, sponsoring or having certain relationships with hedge funds or private equity funds (referred to as “covered funds”).

As required by the Dodd-Frank Act, the final rules provide exemptions for certain activities, including market making, underwriting, hedging, trading in certain government obligations and organizing and offering a hedge fund or private equity fund, among others. Like the Dodd-Frank Act, the final rules limit these exemptions if they involve a material conflict of interest; a material exposure to high-risk assets or trading strategies; or a threat to the safety and soundness of the banking entity or to U.S. financial stability.

Covered Funds. Unless done in compliance with the conditions discussed below under “Permitted Activities”, the final rules prohibit banking entities from owning and sponsoring covered funds. Under the final rules, the definition of “covered funds” encompasses any issuer that would be an investment company under the Investment Company Act if it were not otherwise excluded by sections 3(c)(1) or 3(c)(7) of that Act. The final rules also include in the definition of covered funds certain foreign funds and commodity pools.

Registered Investment Companies. Registered investment companies and business development companies are not treated as covered funds under the final rules. The five federal agencies finalizing the rules did not believe it would be appropriate to treat as covered funds entities that are regulated by the SEC as investment companies. The final rules also exclude from the definition of covered funds certain entities with more general corporate purposes such as wholly-owned subsidiaries, joint ventures and acquisition vehicles.

Permitted Activities. The final rules permit a banking entity to invest in or sponsor a covered fund, subject to the following conditions:

  • the banking entity must provide bona fide trust, fiduciary, investment advisory or commodity trading advisory services to the covered fund;
  • the covered fund must be offered in connection with the provision of the bona fide trust, fiduciary, investment advisory or commodity trading advisory services and only to persons who are customers of the banking entity;
  • the banking entity and its affiliates must comply with limitations that generally restrict ownership in the covered fund to no more than three percent of the outstanding ownership interests in the covered fund within one year of the establishment of the covered fund;
  • the banking entity cannot enter into a transaction with a covered fund that would be a covered transaction as defined in Section 23A of the Federal Reserve Act;
  • the banking entity is prohibited from guaranteeing, assuming or otherwise insuring the obligations or performance of the covered fund;
  • the covered fund is prohibited from sharing the name or a variation of the same name with the banking entity that relies on the exemption and is not permitted to use the word "bank" in its name;
  • directors and employees of the banking entity are prohibited from acquiring or retaining an ownership interest in the covered fund, except for any director or employee who is directly engaged in providing investment advisory or other services to the covered fund; and
  • the banking entity must provide written disclosure to investors and prospective investors that clearly (i) indicates that all investors should read the fund offering documents; (ii) describes the role of the banking entity and its affiliates and employees in sponsoring or providing any services to the covered fund; and (iii) contains certain representations that ownership interests are not guaranteed by the FDIC and that losses are borne solely by investors in the fund.

The final rules become effective on April 1, 2014 and banks must conform their activities, investments, relationships and transactions to the Volcker Rule by no later than July 21, 2015.

Sources: Agencies Issue Final Rules Implementing the Volcker Rule, SEC Press Release 2013-258 (December 10, 2013); Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, SEC Release No. BHCA-1 (December 10, 2013); Industry Dodges Volcker Rule Bullet, Ignites, Joe Morris (December 11, 2013).

SEC Guidance

SEC Announces 2014 Examination Priorities
The SEC’s National Examination Program (NEP) published its 2014 examination priorities for investment advisers and investment companies.

Safety of Assets and Custody. The NEP continues to observe non-compliance with the custody rule. As we discussed in our April update, the SEC published a Risk Alert in March 2013 sharing observations regarding the most common issues of non-compliance. The safety of assets and custody was an exam priority last year and resulted in several enforcement actions in 2013. Given the importance of this requirement for a fiduciary, the staff will continue to test compliance with the custody rule and confirm the existence of assets through a risk-based asset verification process. Examiners will pay particular attention to those instances where advisers fail to realize they have custody and therefore fail to comply with requirements of the custody rule.

Conflicts of Interest. The staff has observed instances of non-compliance with the federal securities laws very often arise in situations where there are undisclosed conflicts of interest. The staff will therefore conduct examinations focused on conflicts of interest, including:

  • compensation arrangements for the adviser, with a particular focus on undisclosed compensation arrangements and their effect on recommendations made to clients;
  • the allocation of investment opportunities;
  • controls and disclosure associated with side-by-side management of performance-based and strictly asset-based fee accounts;
  • risk controls and disclosure, particularly for illiquid investments and leveraged investment products and strategies; and
  • higher risk products or strategies targeted to retail (and especially retired or elderly) investors.

Marketing/Performance. The staff will review the accuracy and completeness of advisers’ claims about their investment objectives and performance. For example, the staff will review and test hypothetical and back-tested performance, the use and disclosure of composite performance figures, performance record keeping and compliance oversight of marketing. The staff also expects to review marketing efforts arising out of newly effective rules adopted under the JOBS Act.

Payments for Distribution in Guise. The staff will continue its review of the variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same. The staff will assess whether such payments are, in fact, payments for distribution and preferential treatment.

Fixed Income Mutual Funds. The staff will monitor the risks associated with a changing interest rate environment and the impact this environment may have on bond funds and related disclosures of risks to investors.

Money Market Funds. The staff will continue targeting some examinations at money market funds, focusing particularly on how they have managed any potential stress events and working with Division of Investment Management staff to examine particular money market funds that exhibit outlier behavior in some respect. Cases brought in 2013 involving money-market fund operations include Ambassador Capital Management, LLC (discussed in this update).

Alternative Investment Companies. The staff will continue its assessment of funds offering alternative investment strategies, with a particular focus on: (i) leverage, liquidity and valuation policies and practices; (ii) the staffing, funding, and empowerment of boards, compliance personnel, and back-offices; and (iii) the manner in which such funds are marketed to investors. The staff will additionally review the representations and recommendations made regarding the suitability of such investments.

Securities Lending Arrangements. The staff will examine securities lending arrangements to determine whether they comply with exemptive orders and evaluate consistency with relevant no-action letters.

Wrap Fee Programs. The staff will assess whether advisers are fulfilling their fiduciary and contractual obligations to clients and will review the processes in place for monitoring wrap fee programs recommended to advisory clients, related conflicts of interest, best execution, trading away from the sponsor and disclosures.

Quantitative Trading Models. The staff will examine advisers with substantial reliance on quantitative portfolio management and trading strategies and assess, among other things, whether these firms have adopted and implemented compliance policies and procedures tailored to the performance and maintenance of their proprietary models, including such procedures as: (i) evaluating if any models are used to manipulate the markets; (ii) reasonably reviewing or testing the models and their output over time; (iii) maintaining proper documentation within required books and records; and (iv) maintaining a current inventory of all firm-wide proprietary models.

Never-Before Examined Advisers. This initiative will address advisers that have never been examined and are not part of the Presence Exam initiative (referenced below). The staff will utilize a number of strategies to conduct focused, risk-based examinations of the adviser population that has been registered for more than three years but has not yet been examined by the NEP.

Presence Exams. The staff will continue its 2012 initiative to examine a significant percentage of the advisers registered since the effective date of the Dodd-Frank Act. The vast majority of these new registrants are advisers to hedge funds and private equity funds that were not registered or regulated by the SEC prior to the Dodd-Frank Act and have never been examined by the SEC. The staff will continue to prioritize examinations of private fund advisers where the staff’s analytics indicate higher risks to investors, or where there are indicia of fraud, broker-dealer status concerns or other serious wrongdoing. The five key focus areas of these examinations are marketing, portfolio management, conflicts of interest, safety of client assets and valuation.

Source: Examination Priorities for 2014, Office of Compliance Inspections and Examinations, January 9, 2014, available at:

Mutual Funds May Electronically Deliver Written Statements Describing Source of Distributions
Section 19(a) of the Investment Company Act and Rule 19a-1 require that a mutual fund making a distribution from any source other than the fund’s net income provide a written statement to shareholders disclosing the source of the payment (e.g., shareholder capital or capital gains). The SEC’s Division of Investment Management has issued guidance stating that funds may electronically deliver to their

shareholders the required written statement describing the sources of their distributions. The guidance is predicated on compliance with all SEC guidance on electronic delivery including the following requirements:

  • electronic delivery of a notice must be in the form of an email message to the fund shareholder containing the notice or a document link to the notice;
  • the fund (or its intermediary) must have obtained prior consent of the shareholder to receive fund shareholder communications through electronic means; and
  • electronic notices must be sent only to shareholders that have provided consent.

Source: Investment Management Guidance Update No. 2013-11, Shareholder Notices of the Sources of Fund Distributions – Electronic Delivery (November 2013).

SEC Staff Issues Guidance on Fund Names Suggesting Protection From Loss
The SEC’s Division of Investment Management issued guidance encouraging investment companies that expose investors to market, credit, or other risks and whose names suggest safety or protection from loss to consider changing their names to eliminate the potential for investor misunderstanding of the risks associated with an investment in the fund and to avoid being misleading. The SEC has heightened its scrutiny of fund names suggesting safety or protection from loss and it will object to names that may create an impression of safety or absence of risk of loss, where the name does not include qualifying language that defines the scope and limits of such protection.

The guidance provides examples of names the SEC considered problematic. Some funds that seek to manage volatility by investing a portion of the fund’s assets in cash, short-term fixed income instruments or short positions on exchange-traded futures included the term "protected" in their name. The SEC is concerned that these names could convey to investors a level of protection that was not present because the degree to which a managed volatility strategy may succeed or fail is uncertain. The SEC is also concerned with funds that enter into contracts with a third party to make up a shortfall in the net asset value of the fund using the term "protected" in their names. Such protection may be limited by a number of factors such as the credit risk of the third party and the time during which the third party is obligated to make up any shortfall in the fund’s net asset value. Such funds should have names that explain the limitations on the scope of the protection provided by the third party.

Source: Investment Management Guidance Update No. 2013-12, Fund Names Suggesting Protection from Loss (November 2013).

SEC Staff Issues Guidance on Exemption for Advisers to Venture Capital Funds
Rule 203(l)-1 under the Advisers Act exempts from registration advisers to one or more venture capital funds. A venture capital fund is any private fund that: (i) represents to potential investors that it pursues a venture capital strategy; (ii) holds no more than 20% of the amount of the fund’s aggregate capital contributions and uncalled committed capital in assets that are not qualifying investments; (iii) does not borrow or otherwise incur leverage in excess of 15% of the fund’s aggregate capital contributions and uncalled capital commitments; (iv) issues securities that provide a holder with redemption rights only in extraordinary circumstances; and (v) is not registered under the Investment Company Act and has not elected to be treated as a business development company. In response to certain inquiries, the Division of Investment Management provided guidance on whether certain advisers would be able to rely on the venture capital fund exemption.

Intermediate Holding Companies. Under Rule 203(l)-1, funds are required to invest at least 80% of their assets in qualifying investments, defined generally as an equity security issued by a qualifying portfolio company that has been acquired directly by the private fund from the qualifying portfolio company. Venture capital funds that hold their portfolio company investments through an intermediate holding company may disregard an intermediate holding company formed solely for tax, legal or regulatory reasons to hold the fund’s investment in a qualifying portfolio company so long as such intermediate holding company is wholly owned by the fund. The Division of Investment Management’s guidance provides that two or more venture capital funds with the same adviser, or advisers that are related persons, may each invest in the same portfolio company through a single holding company that is not owned by either of the funds, but rather is wholly owned by the funds collectively.

Alternative Investment Vehicles. To accommodate U.S. tax-exempt investors and non-U.S. investors, advisers often form an alternative investment vehicle (AIV) that exists solely to invest in the venture capital fund. The AIV does not invest in qualifying investments and therefore would technically hold more than 20% of the amount of the fund’s aggregated capital contributions and uncalled capital commitments in non-qualifying investments. The Division of Investment Management stated that it would not object if an adviser relying on Rule 203(l)-1 disregards AIVs when determining if it can meet the requirements of the exemption provided the AIV is formed solely to address investors’ tax, legal or regulatory concerns and is not intended to circumvent the exemption’s general limitation on investing in other investment vehicles.

Warehoused Investments. Warehoused investments are investments made by an adviser while a venture capital fund is in the fundraising process, but prior to the fund being able to make investments, that are subsequently transferred to the fund. The Division of Investment Management would not object to warehoused investments being treated as though they were acquired directly by the venture capital fund from the qualifying portfolio company provided that: (i) the warehoused investment is initially acquired by the adviser (or a person wholly owned and controlled by the adviser) directly from a qualifying portfolio company solely for the purpose of acquiring the investment for a prospective venture capital fund that is actively fundraising; and (ii) the terms of the warehoused investment are fully disclosed to each investor in the venture capital fund prior to each investor committing to invest in the fund.

Main Fund/Side Fund Transfers. Advisers will often establish a venture capital fund (Main Fund) and one or more private funds to invest in parallel with the Main Fund (Side Funds). A Main Fund will sometimes transfer securities to the Side Fund(s) so that each holds its pro rata share of portfolio company securities as if each fund had made the investment on the same day on the same terms. The Division of Investment Management stated it would not object to treating such transfer as a qualifying investment provided the transfer occurs within 12 months of the final closing of the Main Fund and the potential for this type of transfer is disclosed in the constituent documents of the Main Fund and Side Funds.

Liquidating Trusts. The Division of Investment Management stated that it would not object to the use of a liquidating trust to acquire the assets of a venture capital fund as it is winding up even though the trust obtains its securities from the venture capital fund itself and not directly from a qualifying portfolio company.

Source: Investment Management Guidance Update No. 2013-13, Guidance on the Exemption for Advisers to Venture Capital Funds (December 2013).

SEC Seeks Public Input on Glide-Path Graphic for Target Date Funds

SEC Chair Mary Jo White indicated in a letter to the Investor Advisory Committee that the SEC would solicit public comments on graphics illustrating target date fund risk. In April 2013, the Investor Advisory Committee recommended that the SEC develop a glide path illustration for target date funds that is based on a standardized measure of fund risk as either a replacement or supplement to its proposed asset allocation glide path illustration. The Investment Advisory Committee also recommended that the SEC adopt a standard methodology to be used in both the risk-based and asset allocation glide path illustrations. SEC staff will develop a draft request for additional comment.

Sources: Letter from Mary Jo White to Joseph Dear, Chairman of the Investor Advisory Committee (November 20, 2013); Joe Morris, SEC Wants Public Input on Glide-Path Graphic, (November 25, 2013); Recommendation of the Investor Advisory Committee (adopted April 11, 2013).

Division of Corporation Finance updates Rule 506 Compliance and Disclosure Interpretations

On December 4, 2013, the staff of the SEC’s Division of Corporation Finance issued new guidance regarding the "bad actor" disqualification provisions of Rule 506(d) of Regulation D under the Securities Act and the related disclosure requirements of Rule 506(e) through an update to its Securities Act Rules Compliance and Disclosure Interpretations (CDIs). Under Rule 506(d), issuers cannot rely on Rule 506 if the issuer, any affiliated issuer, or certain directors, officers or owners of the issuer have been subject to a disqualifying event. The new CDIs provide clarification to issuers seeking to comply with Rule 506(d). Some of the more significant

CDIs relate to the following:

  • Placement Agents. If a placement agent or one of its covered control persons becomes subject to a disqualifying event while an offering is ongoing, the issuer may continue to rely on Rule 506 if the issuer terminates its engagement with the placement agent and the placement agent does not receive any compensation for any future sales in that offering. The issuer may also continue to rely on Rule 506 if the disqualifying event affects only a covered control person of the placement agent, if that person is terminated or ceases to perform a role with respect to the placement agent that would cause him or her to be a covered person with respect to the issuer for purposes of Rule 506(d).
  • Reasonable Care Exception. Rule 506(d) provides a reasonable care exception if the issuer can establish that it did not know, and despite the exercise of reasonable care could not have known, that a disqualification existed under Rule 506. The reasonable care exception may apply where, despite the exercise of reasonable care, the issuer was unable to determine the existence of a disqualifying event, was unable to determine that a particular person was a covered person, or initially reasonably determined that the person was not a covered person but subsequently learned that determination was incorrect.

Source: Securities Act Rules Compliance and Disclosure Interpretations, available at:

Legislative Action

House Passes Bill Exempting Private Advisers From Registration
On December 4, 2013, the House of Representatives passed a bill that would exempt most private equity fund advisers from registering with the SEC. The bill would create an exemption to the registration requirements of the Advisers Act for investment advisers to private equity funds, provided that each such fund has not borrowed and does not have outstanding a principal amount in excess of twice its invested capital commitments. The bill directs the SEC to enact final rules addressing reporting and recordkeeping requirements for exempt advisers and defining the term "private equity fund." The Senate has not proposed a companion bill. The Executive Office of the President issued a Statement of Administration Policy stating that "if the President were presented with H.R. 1105, his senior advisors would recommend that he veto the bill."

Sources: H.R. 1105, Small Business Capital Access and Job Preservation Act (November 22, 2013); House Passes Bill Exempting Private Advisers from Registration, Bloomberg Securities Regulation & Law Report (December 9, 2013); Statement of Administration Policy, Executive Office of the President (December 3, 2013).

SEC Enforcement Actions and Litigation

Advisers Face Lawsuits Over Fees Charged to Subadvised Funds
SEI Investments Management Corporation and Russell Investment Management Company are the latest investment advisers to face lawsuits alleging they violated their fiduciary duties under Section 36(b) of the Investment Company Act by charging excessive fees while managing subadvised funds. In both suits, the plaintiffs allege the advisers are charging excessive fees because the advisers delegate most of the day-to-day management responsibilities to the subadvisers but retain the majority of the advisory fees.

The SEI suit was brought in federal court in Pennsylvania in December 2013 by two plaintiffs on behalf of five funds managed by SEI. Plaintiffs allege that for the 2012 fiscal year, SEI retained $10.3 million of the $27 million in management fees paid by the five funds. At the same time, plaintiffs allege that SEI’s role was limited to general oversight and supervision of the subadvisers. As a result, plaintiffs assert that the investment management fees are disproportionate relative to the services rendered. Plaintiffs also allege that while the funds have grown in size, SEI has not passed on the benefits of economies of scale to investors in the form of lower management fees.

While the funds at issue have charged the same fees for as many as 17 years, the funds have experienced asset growth through additional investments of as much as 307%.

In the Russell suit, brought in October 2013 in federal court in Massachusetts, the plaintiff brought suit on behalf of ten subadvised funds managed by Russell. The plaintiff alleges that for the 2012 fiscal year, Russell retained $107 million of $164 million in investment management fees paid by the ten funds in question while subcontracting with others to provide the services at a lower fee than that charged to the funds in question. The plaintiff alleges that this left Russell without any substantive asset management responsibilities. The complaint alleges that Russell’s responsibilities are minimal compared with the day-to-day responsibilities of managing the portfolio and as such Russell’s fees should be proportionately smaller than the fees paid to the subadvisers. As in the SEI suit, the plaintiffs also allege that the cost savings experienced by economies of scale in the funds were not shared with the funds.

Sources: Steven Curd and Rebel Curd v. SEI Investments Management Corporation, Case 2:13-cv-07219-AB (December 11, 2013); Fred McClure v Russell Investment Management Company, Case 1:13-cv-12361 (October 17, 2013); SEI Latest Firm Hit With Excessive-Fee Lawsuit, Beagan Wilcox Volz, Ignites (December 16, 2013); Russell Latest to Face New Breed of Excessive-Fee Suit, Beagan Wilcox Volz, Ignites (October 24, 2013).

Hedge Fund Adviser and Holding Company Agree to Pay Nearly $9 Million in SEC Settlement for Overvaluing Fund Assets
GLG Partners, L.P., a London-based hedge fund adviser that managed GLG Emerging Markets Special Assets 1 Fund, and its former U.S.-based holding company, GLG Partners, Inc., were charged with internal control failures that led to the overvaluation of the fund’s assets and inflated fee revenues for the GLG firms. "Investors depend upon fund advisers to have proper controls in place to ensure that valuations and fees are not inflated," said Antonia Chion, an associate director in the SEC’s Division of Enforcement. "GLG’s pricing committee did not have the information and time it needed to properly value assets."

According to the SEC’s order instituting settled administrative proceedings, GLG’s internal control failures caused the overvaluation of the fund’s 25% private equity stake in a Siberian coal mining company by approximately $160 million for 25 months, resulting in inflated fee revenue of $7,766,667 to the GLG firms and the overstatement of assets under management in the holding company’s filings with the SEC.

GLG’s asset valuation policies required the valuation of the coal company’s position to be determined monthly by an independent pricing committee. According to the SEC’s order, GLG employees received information on a number of occasions calling into question the $425 million valuation for the coal company position, but there were inadequate policies and procedures to ensure that such relevant information was provided to the independent pricing committee in a timely manner or even at all. According to the SEC, there was confusion among GLG’s fund managers, middle-office accounting personnel, and senior management about who was responsible for elevating valuation issues to the independent pricing committee.

The order requires the GLG firms to hire an independent consultant to recommend new policies and procedures for the valuation of assets and test the effectiveness of the policies and procedures after adoption. The order directs the GLG firms to cease and desist from violating or causing violations of various provisions of the federal securities laws. The GLG firms consented to the order without admitting or denying the charges. The SEC is establishing a fair fund to distribute money to harmed fund investors. The GLG firms agreed to pay disgorgement of $7,766,667, prejudgment interest of $437,679 and penalties totaling $750,000.

Sources: In the Matter of GLG Partners, Inc. and GLG Partners, L.P., Administrative Proceeding File No. 3-15641 (December 12, 2013); SEC Charges London-Based Hedge Fund Adviser and U.S.-Based Holding Company for Internal Control Failures, SEC Press Release 2013-259 (December 12, 2013).

SEC Sanctions CEO and CCO of Formerly Registered Investment Adviser for Custody Rule Violations; Accountants Barred from SEC Practice for Failure to Complete Surprise Examination
On December 12, 2013, the SEC issued an order instituting settled administrative proceedings against Mark Wayne, the former President, CEO and CCO of Freedom One Investment Advisors, Inc., an adviser formerly registered with the SEC, for violations of the custody rule under the Advisers Act.

Freedom One had custody of client assets held in two omnibus accounts, one for IRA accounts and one for managed accounts, from 2008 to 2010. According to the SEC’s order, Freedom One hired an accounting firm to conduct a surprise exam in 2008 but the accounting firm never completed the exam. In 2009 and 2010, Freedom One engaged a different accounting firm to conduct surprise exams, but the exams were insufficient because Freedom One told the firm that only the IRA accounts were subject to the exam and thus the exams did not include the managed accounts. The SEC found that Freedom One violated the custody rule for all three years because it took no action to determine whether the independent public accountants it retained to conduct annual surprise exams sufficiently performed those exams. In addition, the SEC found that Freedom One violated the custody rule requirement regarding delivering client account statements. From 2008 through 2010, an affiliate of Freedom One, which was not a qualified custodian, provided quarterly account statements to clients with IRA accounts and managed accounts.

The SEC also found that Freedom One violated the Advisers Act compliance rule by failing to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the custody rule. Freedom One was also found to have violated the books and records rule by failing to record certain Freedom One transactions in its books and records.

Mr. Wayne was found to have aided and abetted Freedom One’s violations. Mr. Wayne consented to the order without admitting or denying the charges. As a result of the findings, Mr. Wayne was barred from acting as the CCO of any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent or nationally recognized statistical rating organization with the right to apply for reentry after one year. The order also requires Mr. Wayne to pay a civil penalty of $40,000.

The SEC not only brought an action against Mr. Wayne, it also brought charges against the accountants who failed to complete the surprise examination in 2008. In an order instituting settled administrative proceedings against them, the accountants, without admitting or denying the charges, agreed to cease and desist from violating the Advisers Act and agreed to a bar from appearing or practicing before the SEC as an accountant.

Sources: In the Matter of Mark M. Wayne, Investment Advisers Act Release No. 3737, (December 12, 2013); In the matter of Rodney A. Smith, Michael Santicchia, CPA and Stephen D. Cheaney, CPA, Investment Advisers Act Release No. 3738 (December 12, 2013).

SEC Files Complaint Against Money Market Fund Adviser and Portfolio Manager
The SEC instituted cease-and-desist proceedings against Ambassador Capital Management, LLC, a Detroit-based registered investment adviser, and Derek Oglesby, one of its portfolio managers, in connection with the management of the Ambassador Money Market Fund, a prime money market fund that was liquidated in June 2012. From time to time, more than half of the shareholders’ investments in the fund came from just two municipalities, the City of Detroit and Washtenaw County, Michigan.

A money market fund may only invest in securities determined by the fund’s board to present minimal credit risk. The order alleges that Ambassador and its portfolio manager repeatedly made false statements to the fund’s board about the credit risk of the securities they purchased for the fund’s portfolio, the fund’s exposure to the Eurozone credit crisis of 2011 and the diversification of the fund’s portfolio.

“Money market fund managers must not hide the ball from a fund’s board,” said George S. Canellos, co-director of the SEC’s Enforcement Division. “Ambassador Capital Management and Oglesby weren’t truthful about whether securities in the portfolio threatened to destabilize the fund, and they failed to operate under the strict conditions designed for money market fund managers to limit risk exposure and maintain a stable price.”

The enforcement action stems from an ongoing analysis of money market fund data by the SEC’s Division of Investment Management.

According to the SEC’s order, the fund consistently had generated a return which significantly exceeded that for the prime money market funds in its peer group. The fund also owned securities issued by Dexia, SA, a French-Belgian bank, after it was taken into receivership by France, Luxembourg and Belgium in October 2011. Further, the fund held the asset backed commercial paper of a troubled German bank and two Italian issuers. Given these concerns, the SEC conducted a compliance examination of the fund in November 2011. During that examination, the Wall Street Journal reported that Moody’s issued negative ratings actions on 12 German banks, two of which sponsored asset backed commercial paper held by the fund. However, Ambassador’s chief investment officer allegedly was unaware of these downgrades. The SEC referred the matter to the SEC Enforcement Division’s Asset Management Unit for investigation.

The SEC alleges that Ambassador and Mr. Oglesby misrepresented or withheld critical facts from the fund’s board, such as:

  • The firm’s self-imposed holding period restrictions were frequently exceeded for securities in the fund’s portfolio.
  • The fund regularly purchased securities that had greater than minimal credit risk under the firm’s own guidelines. Ambassador allegedly failed to comply with Rule 2a-7 under the Investment Company Act by repeatedly purchasing portfolio securities without making a determination that the securities posed a minimal credit risk and by failing to keep a written record of its analysis. Ambassador’s credit analyses concluded that many of the fund’s securities presented “risk,” “some risk” or “moderate risk.”
  • Throughout the Eurozone credit crisis in 2011, the fund continually purchased securities issued by Italian-affiliated entities despite Mr. Oglesby’s claim that Ambassador was trying to stay away from Italian exposure and would unload even secondhand exposure to the Italian market.
  • The fund’s portfolio was not sufficiently diversified.

According to the SEC’s order instituting administrative proceedings, Ambassador also caused the fund to deviate from the risk-limiting provisions of Rule 2a-7. The SEC alleges that since the fund failed to follow Rule 2a-7, it was not permitted to use the amortized cost method of valuing securities under which it priced its securities at $1 per share and the fund also should not have been represented to investors as a money market fund.

“Compliance with the risk-limiting provisions is critically important for a money market fund. Deviations can have serious consequences for pricing of fund shares and how the fund markets itself to investors,” said Marshall S. Sprung, co-chief of the SEC Enforcement Division’s Asset Management Unit.

Finally, the SEC alleges that Ambassador also failed to conduct an appropriate stress test of the fund’s portfolio. Rule 2a-7 requires money market funds to implement written procedures providing for periodic stress testing of the fund’s ability to maintain a stable NAV in light of several hypothetical scenarios. The complaint alleges that the fund did not fully implement written stress testing procedures until May 2012. Ambassador also allegedly failed to perform adequate stress testing by failing to include some hypothetical scenarios required by Rule 2a-7 in its stress testing of the fund.

The SEC’s order alleges that Ambassador violated the antifraud provisions of the Advisers Act and Mr. Oglesby aided and abetted the firm’s violations. They allegedly caused violations of the pricing, naming and recordkeeping provisions of the Investment Company Act, and the firm caused violations of the compliance rule.

A hearing has been scheduled for May 5, 2014.

Sources: In the Matter of Ambassador Capital Management, LLC and Derek H. Oglesby, Administrative Proceeding File No. 3-15625 (November 26, 2013); In the Matter of Ambassador Capital Management, LLC and Derek H. Oglesby, Administrative Proceeding File No. 3-15625 (January 7, 2014).

The information contained herein is based on a summary of legal principles. It is not to be construed as legal advice. Individuals should consult with legal counsel before taking any action based on these principles to ensure their applicability in a given situation.

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