SEC Files Another Action Against an Advisor

Investment advisers are a continuing focus of SEC Enforcement. During the last government fiscal year actions involving investment advisers and firms were the second largest category of cases. Indeed, the trend in recent years has reflected increasing numbers of actions involving investment advisers.

The Commission’s most recent case in the area is SEC v. Direct Lending Investments LLC, Civil Action No. 2:19-cv-218 (C.D. CA. Filed March 22, 2019). Direct Lending is an unregistered investment adviser owned by Brendan Ross. The firm serves as the adviser for two feeder funds and a master fund. Direct Lending is solely responsible for the management of those funds. The California based advisor is not registered with the Commission.

The advisor purchased loans, participations in loans and credit facilities. Clients were charged a management fee of 1% of the master fund’s gross asset value. A performance fee was also charged when the net asset value of the master fund exceeded its prior high net asset value and was calculated as 20% of those earnings before interest and taxes. In communications with investors the advisor repeatedly touted its strong, consistent returns. Returns of 10% to 12% were claimed with no down months.

QuarterSpot was a key investment for the adviser. The New York based firm was an on-line lender. In late September 2017 the adviser sold about $55 million of its QuarterSpot holdings to an investment vehicle operated by a business associate of Mr. Ross who guaranteed the transaction. The deal essentially cut Direct Lending’s QuarterSpot holdings in half. Nevertheless, the adviser remained involved in processing loan information for QuarterSpot loans.

Beginning in 2014, and continuing for the next four years, Mr. Ross knew about difficulties with the QuarterSpot loan portfolio from the available loan data. During that four year period he sought to conceal those issues and urged the company to manipulate its results. Those efforts are reflected in a series of communications involving Mr. Ross and the company. This resulted in the falsification of QuarterSpot payment information. That in turn caused the adviser to materially overstate the value of its position in the company by about $53 million between 2014 and 2017. As a result, the adviser collected about $11 million in excess fees.

By late 2018 certain borrower payment data on the advisors’ books did not match that of QuarterSpot. By early 2019 QuaerterSpot representatives refused to respond to questions on the subject.

In February 2019 the advisor announced that the Funds had suspended withdrawals and redemptions because one of its largest counterparties ceased making payments on a significant loan. The next month Direct Lending announced that another position – QuarterSpot—may have been materially overstated for a period of years. Mr. Ross resigned after being requested by the management committee to take a leave of absence. The complaint alleges violations of Advisers Act Sections 206(1), 206(2) and 207, Exchange Act Section 10(b) and Securities Act Section 17(a).

The advisor consented to the entry of a permanent injunction based on the sections cited in the complaint. The firm also agreed to the appointment of a receiver. The complaint seeks additional relief. See Lit. Rel. No. 24432 March 25, 2019).

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Commission Sanctions Merrill Re ADRs

Commission enforcement actions involving market professionals tend to repeat. For example, many, if not most, of the cases brought against investment advisers focus on violations of the advisor’s procedures. In some instances, however, the Enforcement staff uncovers a violation and then discovers similar issues at other firms. This was the pattern with the share class disclosure selection cases where advisers failed to disclose the inherent conflict when acquiring mutual fund shares for clients if the fund offered institutional shares and others which had fees.

The latest variation of these themes is pre-release ADRs. To date the Commission has brought nine actions against banks and brokers who borrowed pre-release ADRs but failed to comply with the obligation to ensure that the actual shares were available – a practice which impermissibly causes the number of shares to be falsely inflated.

The Commission’s most recent ADR case is In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Adm. Proc. File No. 3-19114 (March 22, 2019). The Bank of America subsidiary has been involved with pre-release ADRs since the early 1990s. After engaging in various transactions involving pre-release ADRs the broker halted the practice. Merrill concluded that its lending desk could not comply with the obligations imposed by the pre-release agreements.

Typically, when ADRs are issued a specific number of shares represented by the ADR are delivered to the Custodian institution. This effectively removes the shares from the market. The ADR represents those shares, keeping the total number of shares outstanding the same.

A “pre-release” transaction is supposed to be effected under a Pre-Release Agreement. The agreement permits the market participant to obtain newly issued ADRs from the Depository rather than purchasing existing ADRs on the market without simultaneously delivering the corresponding ordinary shares to the depository. The agreement typically provides that the pre-release broker or its customer beneficially owns corresponding ordinary shares, assigns all beneficial right title and interest in the shares to the depository and will not take any action with respect to the shares that is inconsistent with the transfer of beneficial ownership.

These provisions ensure that the number of shares available remains the same. The traditional rationale for these agreements is “timing.” Specifically, the agreements were typically used in situations in which there may be a delay in delivering the shares to the custodian because of a recent transaction which was expected to close shortly.

Beginning in 2012, and continuing for the next two years, Merrill re-entered the pre-release market. During that period the firm engaged in over 40,000 transactions in which it obtained ADRs from pre-release brokers which had obtained the securities from the depository. The broker borrowed the securities under standard master securities loan agreement with pre-release brokers which did not address pre-release ADRs and did not contain any provisions requiring Merrill to satisfy the pre-release obligations. The transactions thus had the effect of falsely inflating the number of shares available.

Merrill knew, or should have know, under the circumstances, that the pre-release brokers were not complying with their obligations. First, the lending personnel knew that the pre-release brokers were in fact conduit lenders that routinely sourced securities through pre-release transactions with depositories. Second, the firm’s lending personnel should have realized that the pre-release brokers were not complying with their obligations. The key was the pricing – the standard transaction would have been priced differently than ones involving pre-release ADRs. Over the period Merrill benefited from the pricing differential, netting about $4.4 million.

During the two year period Merrill did not have any policies and procedures that would be reasonably expected to detect whether the securities lending desk was involved in pre-release transactions. The firm also failed to reasonably supervise the personnel on the lending desk. The Order alleges violations of Securities Act Section 17(a)(3).

In resolving the matter the Commission considered the cooperation of Respondent.

To resolve the proceedings Merrill consented to the entry of a censure. The firm also agreed to pay disgorgement of $4,448,291.52 and prejudgment interest of $724,795.40. In addition, the firm will pay a penalty of $2,891,389.48.

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