On January 11, 2011, the SEC announced the settlement of administrative proceedings against an ultra-short bond fund (the “Ultra-Short Fund”) and a broad bond market index fund (the “Total Market Bond Fund”) (collectively, the “Funds”) and the Funds’ investment adviser (the “Adviser”) and affiliated distributor and transfer agent (the “Distributor”). The SEC’s principal findings were that, between 2005 and mid-2008, (i) the Adviser and the Distributor made misleading comparisons in marketing the Ultra-Short Fund as an alternative to cash management vehicles like money market funds without adequately disclosing the Fund’s relative risks and the differences between the Fund and other cash management vehicles, particularly money market funds; (ii) the Adviser and Distributor made inaccurate statements about the Ultra-Short Fund’s declining net asset value (“NAV”) during the credit crisis of 2007-2008; (iii) the Adviser and Distributor improperly substituted the Ultra-Short Fund’s duration for its weighted average maturity (“WAM”) in certain marketing materials and SEC filings; (iv) each Fund deviated from its industry concentration policy when it invested more than 25% of Fund assets in non‑agency mortgage-backed securities (“MBS”); and (v) the Adviser and Distributor failed to establish and implement internal controls reasonably designed to prevent the misuse of material, nonpublic information about the Ultra-Short Fund. This article discusses highlights of the SEC’s findings along with a related FINRA settlement with the Distributor.
Misleading Comparisons. The Ultra-Short Fund was marketed in sales materials as a cash alternative that provided a higher yield with slightly more risk than a money market fund. The SEC found that investors were not adequately informed about the Ultra-Short Fund’s relative risks and, more specifically, about possible fluctuations in the Fund’s NAV and about differences in the maturities and credit quality of the securities held by the Fund compared to securities held by money market funds. Although the Ultra-Short Fund’s prospectus better explained these differences, the prospectus disclosure did not cure the deficiencies in how the Fund was marketed.
Declining NAV. In the summer of 2007, during the unfolding credit crisis, the Ultra-Short Fund’s NAV began to decline, and it experienced significant redemptions. The SEC found that the Adviser and Distributor made inaccurate statements and omissions regarding the Ultra-Short Fund’s redemption activity by stating that the Fund was selling securities to raise cash to capitalize on investment opportunities in the current market environment and to meet redemptions and that the Fund’s short maturity structure mitigated price erosion experienced by some of the Fund’s peers. The Adviser and Distributor held a series of conference calls and issued written materials to investors and their financial advisors stating that the decline in the Ultra-Short Fund’s NAV represented unrealized, rather than realized, losses. The Ultra-Short Fund’s lead portfolio manager misled investors by understating the Fund’s outflows as “minimal” when the Fund had sold over $2 billion in assets to satisfy redemption requests.
Ultra-Short Fund’s Weighted Average Maturity (“WAM”). During 2006-2007, the SEC found that the Adviser and Distributor substituted the Ultra-Short Bond Fund’s duration for its WAM in certain marketing materials and in an annual shareholder report filed with the SEC. During the relevant period, the Ultra-Short Fund’s duration was less than its WAM. The Adviser and Distributor did not make this substitution for any other affiliated fund. In some instances, the replacement figure was footnoted to indicate that it represented duration, but in various sales materials and one filing with the SEC, the footnote was omitted. In addition, the Adviser and Distributor fixed the Ultra-Short Fund’s duration in the various listings at 0.5 when it in fact fluctuated between 0.4 and 0.6.
Deviation from the Funds’ Concentration Policies. Each Fund’s registration statement disclosed that it would not concentrate more than 25% of its assets in any industry and identified non-agency MBS as an industry. Pursuant to Section 13 of the Investment Company Act of 1940, as amended (the “1940 Act”), any change in the concentration policy would require shareholder approval. The SEC found that by early 2006, the Ultra‑Short Fund, at the Adviser’s direction, exceeded its concentration limit; the Fund also mischaracterized non-agency MSB securities held by the Fund in SEC filings thereby disguising the deviation from its concentration policy. The Adviser then sought and received from the Fund’s board of trustees approval of a concentration policy change that reclassified non-agency MBS so that they were no longer an industry. No shareholder approval of these changes was sought. The Total Market Bond Fund subsequently increased its investment in non-agency MBS above 20% of the Fund’s assets, and the Ultra‑Short Fund increased its investment in non-agency MBS to 50% of assets. The SEC also found that the Funds had failed to follow the proper procedure for disclosing the change in policy in their registration statement filings. The revised concentration policies were disclosed in a filing pursuant to Rule 485(b) under the Securities Act of 1933 (the “1933 Act”), which is available, with respect to changes in substantive content, only if the filer is providing certain financial information or information about portfolio managers, or making non-material changes. The SEC found that the concentration policy change was material and consequently the Funds’ filing should have been made pursuant to Rule 485(a) under the 1933 Act; the SEC staff typically reviews Rule 485(a) filings.
Misuse of Material Nonpublic Information. Neither the Adviser nor the Distributor had adequate policies in place to prevent the misuse of material nonpublic information about the Fund, taking into consideration the nature of their businesses. The SEC found that the Adviser and Distributor failed to maintain appropriate information barriers concerning nonpublic and potentially material Fund information. The Adviser and Distributor did not have policies in place to review redemptions of Fund shares by all their personnel and the funds they sponsored for compliance with the general policy. Although certain personnel, including the Ultra-Short Fund’s portfolio managers, had to obtain pre-approval of their redemptions of Fund shares, there was no policy requiring pre-approval of redemptions of Fund shares by other personnel of the Adviser and Distributor whose duties provided them with material nonpublic information about the Ultra-Short Fund, and there were no specific policies and procedures governing redemptions by portfolio managers who managed affiliated funds of funds. Consequently, an affiliated charitable fund and several affiliated funds of funds were able to redeem their shares of the Ultra-Short Fund during its decline based on material nonpublic information.
Violations. The SEC found that: (i) the Adviser and Distributor willfully violated Sections 17(a)(2) and (3) of the 1933 Act in connection with the misleading statements and willfully aided and abetted and caused violations of Section 34(b) of the 1940 Act; (ii) the Adviser willfully violated the anti-fraud provisions of Section 206(4) of the Advisers Act of 1940 (the “Advisers Act”) and Rule 206(4)-8 thereunder for its misleading statements; (iii) the Fund’s trust willfully violated Section 13(a) of the 1940 Act by violating the Funds’ concentration policy, and the Adviser aided and abetted and caused the violation; and (iv) the Distributor violated Section 15(g) of the Securities Exchange Act of 1934 and the Adviser violated Section 204A of the Advisers Act by failing to establish, maintain and enforce adequate written policies and procedures to prevent the misuse of material nonpublic information.
Penalties. Without admitting or denying the SEC’s allegations or findings, the Adviser and the Distributor agreed to pay a total of $118,994,996, including $52,237,149 in disgorgement of fees by the Adviser, a penalty by the Adviser of $52,237,149, a penalty of $5 million by the Distributor and prejudgment interest of approximately $9.2 million. The Adviser, Distributor and the Funds also consented to an SEC order requiring them to cease and desist from committing or causing future violations of the federal securities laws. The SEC order requires them to comply with certain undertakings, including correction of all disclosures regarding the Funds’ concentration policies. In addition, the SEC censured the Adviser and Distributor, and required them to retain an independent consultant to review and make recommendations about their policies and procedures to prevent the misuse of material nonpublic information.
FINRA Settlement. FINRA concurrently announced its settlement with the Distributor, requiring it to pay $18 million for improper marketing of the Fund, including misleading statements and material omission of information about the Fund.
SEC Complaint Against Former Lead Portfolio Manager of Ultra-Short Fund and Former Adviser President. The SEC also filed a separate complaint based on the same underlying facts against (a) the former lead portfolio manager of the Ultra‑Short Fund, who also formerly served as the chief investment officer of the fixed income funds sponsored by the Adviser, and (b) the former president of the Adviser, who was also a trustee of the Ultra-Short Fund and is currently an executive vice president of the Distributor, alleging similar securities law violations as well as scienter-based claims.