The Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”) announced parallel enforcement orders against an investment adviser (the “Adviser”) and its Chief Executive Officer for derivatives-related oversight failures. The alleged failures related to the Adviser’s management of a registered investment company that invested primarily in options on stock-index futures contracts. The Adviser was regulated by the SEC and the CFTC as a registered investment adviser and registered commodity pool operator (“CPO”), respectively.
This blog post will summarize these enforcement orders, since we believe that they are relevant to investment advisers subject to joint oversight by the SEC and the CFTC. As a general matter, we also believe that this matter highlights the importance of disclosure and consistent risk management practices in connection with any advisory client’s derivatives-based investment strategy.
On January 27, 2020, the SEC and the CFTC announced parallel enforcement orders against the Adviser and its Chief Executive Officer for their failure to comply with the Investment Advisers Act of 1940 (the “Advisers Act”) and the Commodity Exchange Act (the “CEA”), respectively.
The Alleged Failures
The alleged failures related to the Adviser’s management of a registered investment company (the “Fund”) that, in pertinent part, used options on stock index futures contracts to implement its investment strategy. The agencies specifically alleged that:
- The Adviser and its employee who served as the Fund’s portfolio manager (the “Portfolio Manager”) made material misrepresentations to investors in marketing documents and telephone calls with investment advisers concerning the risk management procedures used by the Adviser manage the Fund;
- For example, the Adviser and the Portfolio Manager stated that stop loss measures were in place that would result in the exiting of a position, if the Fund’s losses reached a specified level;
- The Adviser made misrepresentations to investors (i.e., in the Fund’s prospectus) that the Adviser employed strict risk management procedures to make necessary adjustments to the Fund’s investment exposures under changing market conditions;
- For example, the Adviser disclosed that it had written risk management procedures regarding “corrective actions” that would be taken if specific risk parameters were breached;
- According to the CFTC’s order, the Adviser’s risk manager failed to review the Fund’s risk metrics on a daily basis;
- The Adviser’s Chief Executive Officer did not implement a supervisory system to effectively oversee the Portfolio Manager;
- For example, the CEO was aware of significant risks of loss in the portfolio, had a discussion with the Portfolio Manager about reducing those risks, but did not follow up with the Portfolio Manager to make sure that he actually took steps to reduce those risks before those losses were incurred;
- The Fund lost approximately 20% of its net asset value – more than $700 million – during the period from December 2016 through February 2017.
The Alleged Violations
The SEC and the CFTC determined that the Adviser violated anti-fraud prohibitions, investor protections and disclosure-related requirements under the Advisers Act and the CEA, respectively. Also, both agencies determined that the Adviser failed to supervise the Portfolio Manager in a manner that would prevent violations of the applicable laws.
- The SEC alleged violations of:
- Section 206(2) of the Advisers Act, the general anti-fraud prohibition;
- Section 206(4) of the Advisers Act and related Rule 206(4)-8, a prohibition against untrue statements by an investment adviser to a pooled investment vehicle; and
- Section 203(e)(6) of the Advisers Act, which relates to a failure by a supervisor (such as a chief executive officer) to supervise those under supervision in a manner that prevents a violation of the securities laws.
- The CFTC alleged violations of:
- Section 4o(1)(B) of the CEA, the general anti-fraud prohibition;
- CFTC Regulation 166.3, which relates to a failure by a CFTC registrant to diligently supervise its employees (for example, by failing to have a supervisory system to detect and deter false and misleading statements by its employees to investors about risk management); and
- Section 13(b) of the CEA, which establishes liability for the executives of a CFTC registrant (such as the chief executive officer or other control persons) who fail to maintain a supervisory system that prevents the Registrant’s employees from violating the CEA (such as the disclosure and risk management failures alleged in the this matter).
Finally, the SEC and the CFTC also filed a complaint against the Portfolio Manager for making fraudulent misrepresentations regarding the management of risk in the Fund.
$10.5 Million: The Combined Settlement Amount to Settle the Charges
The agencies ordered the Adviser and its Chief Executive Officer to pay a combined amount of approximately $10.5 million to settle the charges. (Of that amount, $300,000 represented a civil monetary penalty assessed against the Chief Executive Officer.)
Derivatives Disclosure and Risk Management Practices Matter
Every investment adviser that is jointly regulated by the SEC and the CFTC should make note of this enforcement matter. To our knowledge, this is the first parallel enforcement action brought by the two agencies since 2012, the year in which the CFTC amended its Regulation 4.5 so as to require many investment advisers to mutual funds that use derivatives to register with the CFTC as a CPO.
Moreover, we believe that this matter highlights the importance of disclosure and risk management practices in connection with any advisory client’s derivatives-based investment strategy (i.e., not just mutual funds). Specifically, investment advisers should evaluate their derivatives risk management procedures, particularly in light of any statements made to clients in disclosure and marketing documents. An investment adviser should also document its audit of and compliance with its derivatives risk management procedures. The adviser should remedy any related failures as soon as possible, in order to reduce the likelihood that those failures may contribute to or result in losses to the adviser’s clients.
The SEC’s order and complaint are available here. The CFTC’s order and complaint are available here.
Good day. Good to keep track of derivatives risk management and related disclosure practices. DR2