The U.S. Securities and Exchange Commission (“SEC”) recently instituted a cease-and-desist proceeding against an SEC registered investment adviser firm and its principal for failure to disclose material information to a client regarding promissory notes issued by a third-party, which eventually was charged in June 2018 by the SEC with an offering fraud and placed under receivership in December 2018. Click here to view the SEC order in this matter; the following is a summary of the SEC’s allegations in this matter, RIA Compliance Consultants, Inc. has not verified the accuracy of such allegations.
Instances When the Investment Adviser Allegedly Received Adverse Financial Information
The SEC alleged that prior to issuer of the promissory notes being charged by the SEC, the investment adviser firm and its principal negligently withheld material adverse financial information about the promissory note issuer to the client who was evaluating its investment of $1.25 million of the issuer’s promissory notes as follows.
– In March 2017, the issuer allegedly indicated to the investment adviser firm’s principal that SEC staff had indicated to issuer that the promissory notes were not properly registered.
– In approximately March 2017, the investment adviser firm’s principal supposedly learned from the issuer’s principal that that one of the issuer’s banking relationship had been terminated.
– In May 2017, the investment adviser firm’s principal purportedly received information that raised questions about the financial condition of the promissory note issuer.
- The principal of the promissory note issuers informed the investment adviser firm’s principal that the issuer planned to re-state financial statements for 2015.
- The principal of the investment adviser firm’s principal allegedly reviewed the restated 2015 financial statement reflecting (i) that the promissory note issuer operated at a net loss of approximately $7 million in 2015, rather than net income of $11 million that was previously reported, (ii) that total assets had been overstated by approximately $54million, (iii) that liabilities exceeded assets, in contrast to the prior statements, and (iv) a shareholder’s deficit of over $12 million, compared to previously reported retained earnings of approximately $20 million.
- The restated financial statements also included a note expressing substantial doubt about promissory note issuers ability to continue operating as a going concern.
– In July 2017, the investment adviser firm’s principal allegedly received additional negative information about promissory note issuer’s financial condition.
- The investment adviser firm’s principal purportedly reviewed the promissory note issuer’s restated 2014 financial statements, which the company had made two months prior without informing the investment adviser firm’s principal.
- The revised 2014 financial statements supposedly reported (i) a net loss of approximately $2 million; (ii) that total assets had been overstated by approximately $23 million; (iii) that liabilities exceeded assets, in contrast to the prior statement; and (iv) a shareholder’s deficit of over $5 million, compared to previously reported earnings of approximately $9 million.
- The restated 2014 financial statements also included a note to the financial statements expressing a substantial doubt about promissory note issuer’s ability to continue as a going concern.
- The investment adviser firm’s principal also learned that promissory note issuer had pledged all of the leases and underlying equipment, which the investment adviser firm’s principal understood provided The investment adviser firm’s principal reviewed documents suggesting that issuer’s principal had overextended his personal guarantee, which the investment adviser firm’s principal understood provided additional protection for the leases.
- When the investment adviser firm’s principal requested the 2016 financial statements, the issuer’s principal claimed that those statements would take some time to prepare to ensure accuracy.
– After receiving the financial statements and other information, the investment adviser firm allegedly stopped recommending new or additional investments in the promissory note issuer.
– In January 2018, the investment adviser’s principal was supposedly aware that another client who had entered a limited partnership investment contract with the promissory note issuer and was having difficulties collecting over $2 million that the promissory note issuer owed this other client.
Opportunities Where the Investment Adviser Allegedly Failed to Disclose the Adverse Financial Information
The SEC alleged that the investment adviser firm’s principal negligently withheld material adverse financial information about promissory note issuer from the client who was evaluating whether to maintain an investment in $1.25 million worth of promissory notes managed by the investment adviser firm.
– Immediately prior to a client meeting on January 18, 2018, the investment adviser firm purportedly sent the client a portfolio summary which provided information about all of the client holdings managed by the investment adviser firm and recommend that the client “[s]tay the course” with the portfolios. The investment adviser firm further recommended “[n]o changes at this time.” The portfolio summary described the promissory notes as a position “with low volatility” and claimed the promissory notes position continues to generate exactly according to schedule. According to the portfolio summary, the investment adviser firm expected the promissory notes to continue to generate 8.5% in annual income with a high level of consistency.
– In subsequent client meeting on January 19, 2018, the client emphasized to the investment adviser firm’s principal that the client’s foremost objective was to preserve capital for the client’s disabled beneficiary and the portfolios should be divested of any volatile or risky investments. At this meeting, the client inquired about the holdings identified in the portfolio summary, including promissory notes and asked whether they should stay invested or move the funds to a safer position. The SEC alleged that the investment adviser firm’s principal assured the client that there was no need to make any change to the portfolios’ allocations at that time. The investment adviser firm’s principle purportedly did not disclose to them the adverse financial information about the promissory note issuer’s financial condition that the investment adviser firm’s principal had learned since March 2017. The investment adviser firm’s principal allegedly told the client that the notes were liquid investments with low volatility and the client would be able to access the entire principal of the promissory notes within ninety days of requesting redemption.
– On February 13, 2018, there was another client meeting when the investment adviser firm’s principal once again discussed the portfolio summary sent in January 2018 that stated the portfolios were “geared toward income producing positions with low volatility,” and listed promissory notes as an example of these types of positions. When the client asked the investment adviser firm’s principal if these statements reflected his current opinion, the investment adviser firm’s principal told the client that they did, confirmed his prior representations about the promissory notes, observed that the portfolio investments were performing as intended, and did not recommend any changes to the holdings at that time. During this meeting, the investment adviser firm’s principal did not disclose any adverse financial information that he knew about the promissory note issuer.
– On May 4, 2018, the investment adviser firm’s principal emailed the client a portfolio summary for the first quarter of 2018 and an invoice for services. The 2018 portfolio summary included statements about the promissory notes that were comparable to the statements made in January 2018 about the portfolio summary for 2017, and the recommendation remained the same. The 2018 portfolio summary also included a letter from the investment adviser firm’s principal stating that “all positions in the portfolio are working as intended. We monitor them on an on-going basis daily and will continue to do so.”
In June 2018, after the SEC filed its action against the promissory note issuer, the client learned for the first time that promissory note issuer had restated its financial statements and that the issuer was facing cash flow difficulties. After learning about the SEC’s complaint, client immediately directed the investment adviser firm’s principal to seek full redemption of the promissory notes, but the issuer did not fulfill the redemption request.
SEC’s Order
The SEC’s order finds that the investment adviser firm and its principal violated Section 206(2) of the Investment Advisers Act of 1940. Without admitting or denying the SEC’s findings, the investment adviser firm and its principal agreed to cease-and-desist from future violations of this provision, to be censured, to engage an independent compliance consultant, and to provide notice of the SEC’s order to clients. In addition, the investment adviser firm is ordered to pay disgorgement and prejudgment interest, and the investment adviser firm’s principal is ordered to pay a civil penalty of $75,000.
Additional Resources
Due Diligence – Alternative Investment – Review Form
Posted by Bryan Hill
Labels: Due Diligence, Enforcement, Fiduciary, Financial Statements, Promissory Note, SEC
Tagged: Enforcement, SEC
