In what appears to be the first formal SEC action arising out of the SEC’s recent liquid alt scrutiny and heightened focus on alternative mutual fund managers, the SEC sanctioned an investment adviser to several alternative mutual funds for causing the funds to violate several rules under the Investment Company Act of 1940, primarily for maintaining the funds’ cash collateral for swap transactions at broker-dealer counterparties instead of at the funds’ custodians.
The adviser specialized in event-driven strategies, including merger-arbitrage, through liquid alternative mutual funds, and served as investment adviser to three registered funds and as sub-adviser to several more funds. The SEC said that the adviser relied on total return swaps and portfolio return swaps to execute its strategies. According to the SEC, for a period of at least nine months, the adviser did not cause the funds’ cash collateral for the swaps to be held in the funds’ qualified custodian bank. Instead, the adviser caused the funds’ cash collateral to be held at the broker-dealers who were counterparties to the swap transactions. These broker-dealers were not qualified custodians of fund assets. The SEC pointed out that the collateral could have been held by the brokers pursuant to a tri-party custody agreement among the custodian bank, the counterparty and the fund, but no such structure was in place for these transactions. As a result, the adviser did not ensure that the funds’ assets were held at the funds’ qualified custodians, as required by Section 17(f)(5).
In addition to the custody violation, the SEC said the adviser also caused the funds to violate Section 12 and Rule 12b-1(h), which prohibit mutual funds from considering sales of fund shares in allocating brokerage transactions. According to the SEC, the adviser did not maintain a list of approved executing brokers and did not monitor compliance with the policies and procedures of the funds for which it provided services. The SEC found that Rule 12b-1(h) was violated because a fund is permitted to direct fund portfolio transactions to brokers who sell fund shares only if the fund or the adviser has implemented policies to ensure that broker selection is not influenced by considerations about the sales of fund shares. The adviser did not implement any such policy, and thus caused the fund to violate Rule 12b-1(h).
Finally, because the adviser caused the funds to violate the rules noted above, the adviser also caused the funds to violate Rule 38a-1, which requires funds to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of federal securities laws.
The adviser agreed to pay a $50,000 penalty to settle the SEC’s charges, but did not admit or deny the allegations.
In the Matter of Water Island Capital LLC, SEC Admin. Proc. File No. 3-16385, Inv. Company Act Rel. No. 31455 (Feb. 12, 2015)
Kramer Levin is a member of the EACC New York