On February 7, 2011, the SEC issued an order settling administrative proceedings against a registered investment adviser (the “Adviser”) and the chief executive officer of the Adviser (the “CEO”) regarding the Adviser’s allocation of initial public offerings (“IPOs”). The SEC found that (1) between February 2006 and January 2008 (the “Relevant Period”), two open-end registered investment companies (the “Relevant Funds”) advised by the Adviser improperly took part in a disproportionate number of IPOs (in comparison to much larger funds advised by the Adviser), and (2) (a) the fact that the Relevant Funds had engaged in short-term trading with respect to many of the shares received in such IPOs (“IPO Shares”) and (b) the impact of that IPO participation and short-term trading on the performance of the Relevant Funds were not properly disclosed to the Relevant Funds’ board and shareholders or the SEC. This article summarizes the SEC’s principal findings in the order.
Background. From 2003 to 2007 the Advisor launched a number of new funds and experienced significant growth in assets under management, which resulted in the Adviser being afforded increased access to IPOs. During the Relevant Period the Adviser had compliance policies and procedures in place that mandated that allocations of shares received in IPOs be made “fairly and equitably” according to a “specific and consistent basis …” Similarly, disclosures contained in the Adviser’s Form ADV indicated that allocations were to be made according to the “risk tolerance and account objective guidelines of its clients” and in a manner that was “fair and equitable, consistent with the requirements of the Investment Advisers Act of 1940 and the Investment Company Act of 1940.” In practice, prior to the Relevant Period these polices and procedures typically resulted in the Adviser allocating IPO Shares on a pro rata basis among the clients whose portfolio managers had expressed interest; however, in at least two instances the CEO directed that IPO allocations be made disproportionately in favor of the Relevant Funds. Additionally, during the Relevant Period, the Relevant Funds, which were the Adviser’s most recently launched and smallest funds, received slightly more than 50% of all IPO allocations made by the Adviser. After receiving an IPO allocation the Relevant Funds generally sold some or all of the IPO Shares within 3 days resulting in significant contributions to the positive performance of the Relevant Funds.
Failure to Disclose the IPO Trading. The SEC found that during the Relevant Period none of the prospectuses, statements of additional information or annual reports of the Relevant Funds (the “Disclosure Documents”) disclosed the scope of the Relevant Funds’ participation in IPOs or the material impact that short‑term trading following IPOs had on the performance of the Relevant Funds. Additionally, none of the Disclosure Documents contained any discussion of the risks associated with short-term IPO trading, including the risks that returns might not be sustainable due to the unavailability of IPOs or that the positive impact on performance of short‑term trading could be lessened if the Relevant Funds experienced significant asset growth. Moreover, the Adviser did not disclose to the board of the Relevant Funds the extent to which the Relevant Funds were investing in IPOs, or the material impact that short‑term trading of IPO Shares had on the performance of the Relevant Funds.
Compliance Program Implementation. The SEC found that the Adviser did not sufficiently implement its compliance policies and procedures which (1) required that IPO Shares be allocated “fairly and equitably among the Adviser’s advisory clients according to a specific and consistent basis so as not to … favor or disfavor any client, or group of clients, over any other” and (2) prohibited any advertising or performance materials from being misleading and required that such materials comply with regulatory guidelines. The SEC noted the IPO allocation policies in the Adviser’s Form ADV which stated, among other things, that the Adviser “allocates its participation in [IPOs] according to the risk tolerance and account objective guidelines of its clients[, that the Adviser] evaluates a potential IPO investment in terms of its industry sector, market geography, income and growth potential, and risk and/or company specific characteristics[, and that] [b]ased on these factors, the Adviser then selects the most appropriate accounts for participation in any underwriting allocation [the Adviser] may receive.” The Adviser’s compliance policies and procedures (1) stated that “[f]ailing to disclose any material conditions, objectives, or investment strategies used to obtain the performance advertised” could be misleading, and (2) delegated responsibility for ensuring that the IPO allocation policies and procedures were implemented to the CEO. The SEC found that the Adviser did not sufficiently implement these policies and procedures, and specifically that the CEO had not directed anyone to conduct a review of the IPO allocation process to ensure that the allocation of IPO Shares was consistent with the Adviser’s policies and procedures. Moreover, no review was done of the Disclosure Documents to ensure that they adequately disclosed the contribution of IPOs to the performance of the Relevant Funds.
Compliance Program Resources. The SEC found that the Adviser failed to provide adequate resources to implement its compliance policies and procedures in a timely manner. In this regard, the SEC noted that the Chief Compliance Officer (the “CCO”), who had little prior compliance experience or training, also served in three other full-time executive roles as the firm’s Chief Operating Officer, Chief Financial Officer and Chief Administrative Officer, with little to no staff support. The SEC also noted the Adviser’s significant growth in assets under management and number of funds during the period between 2003 and 2007 and the CCO’s request for additional resources.
Documentation of IPO Indications of Interest and Brokerage Orders. The SEC found that the Adviser failed to adequately document brokerage orders related to indications of interest in IPO allocations. The Adviser’s IPO process required that individual portfolio managers make themselves aware of IPOs and, if interested, submit an indication of interest to the head trader. The SEC noted that the head trader gathered indications of interest related to IPOs in an informal manner, including oral submissions, and that records related to such indications of interest were generally discarded following the IPO. Additionally, the SEC found that the Adviser’s order memoranda for IPO purchases also contained other deficiencies, noting that (1) most were partially completed and time-stamped only at or around the time a trader received a fill for the order from the broker, and (2) many failed to identify the persons who recommended and placed the order.
Violations. The SEC found that: (i) the Adviser willfully violated Sections 17(a)(3) of the 1933 Act, Sections 206(2) and (4) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and Rule 206(4)-8 promulgated thereunder in connection with the failure to disclose the Relevant Funds’ IPO investments and short-term trading with respect to IPO shares; (ii) the Adviser willfully violated Section 34(b) of the 1940 Act by filing, transmitting and/or keeping prospectuses, statements of additional information and annual reports for the Relevant Funds that contained misleading statements of material fact or omissions of fact necessary to prevent the statements in those documents in light of the circumstances in which they were made, from being materially misleading; (iii) the Adviser caused the Relevant Funds to violate Rule 31a-1(b)(5) under Section 31(a) of the 1940 by failing to maintain and preserve a complete record for each brokerage order related to the IPO transactions; (iv) the Adviser violated Section 204 of the Advisers Act and Rule 204(a)(3) promulgated thereunder, as a result of failing to make and keep true and accurate order memoranda for the purchase and sale of IPO shares; and (v) the CEO willfully aided and abetted and caused the Adviser’s violations of Section 206(4) with respect to Rule 206(4)-7 thereunder which requires that the Adviser implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules promulgated by the SEC thereunder.
Remedial Actions and Penalties. Prior to the SEC investigation, the Adviser hired a new Chief Operations Officer and Chief Financial Officer. Additionally, during the course of the investigation the Adviser undertook various other remedial action, including (1) replacing its CCO, (2) voluntarily retaining an independent compliance consultant (“Compliance Consultant”) for the purpose of: (a) reviewing the risks and effectiveness of existing written supervisory and compliance procedures, (b) reviewing the effectiveness of the Adviser’s books and records, (c) assisting in the preparation of additional written policies and procedures for adoption and implementation by the Adviser, and (d) assisting in the preparation of additional written disclosure statements for the Adviser’s use with actual and prospective clients.
In determining to accept the offer of settlement, the SEC considered these remedial actions. In connection with the settlement and without admitting or denying the SEC’s allegations or findings, the Adviser and the CEO agreed to pay $650,000 and $65,000, respectively. The Adviser also agreed to certain undertakings, including, among other things, continuing the Compliance Consultant’s engagement.