Compliance Failures Yield SEC Sanctions For Adviser, CEO
The retail investor focus of SEC Enforcement is translating into an investment adviser focus. The Division’s recently published Report reveals that cases involving investment advisers and investment companies were the second largest group of actions brought in the last fiscal year, just behind offering fraud cases. Those results are in stark contracts with the traditional focus of the Division which typically resulted in issuer disclosure and accounting actions being the leading category of cases.
Many of the investment adviser cases being brought are predicated at least in part, and often largely, on the failure of the adviser to adhere to its policies as disclosed in Form ADV. That is precisely the bases for the Commission’s most recent action against an investment adviser. In the Matter of Pennant Management, Inc., Adm. Proc. File No. 3-18884 (Nov. 6, 2018).
Pennant Management was a registered investment adviser prior to the time the firm was acquired in May 2015. The adviser’s most significant line of business was a repo program which offered clients the opportunity to purchase pro rata shares in nine facilities containing repurchase agreement for portions of loans guaranteed by government entities which included the USDA. The repos were sourced from one of four counterparties.
The adviser marketed the facilities as high yield alternatives to money market funds. Clients were told in the adviser’s Form ADV Part 2A that the firm conducted initial and ongoing due diligence and monitoring of repo counterparties. The brochure also stated that the repo program had liquidity risk since collateral might be illiquid. The adviser, clients were told, assessed risk through its ongoing due diligence.
Despite the representations in its filings, the firm’s procedures were limited to a general practice and the use of a checklist of documents to be obtained as initial due diligence. Counterparties were obligated to provide certain financial information that Pennant Management might reasonably request. No written guidance was provided, however, regarding what information was to be assessed from the documents or what to do with the information. By the end of 2013 Pennant Management clients had invested almost $800 million in the repo program.
In early 2012 Pennant Management was introduced to First Farmers, a USDA approved non-traditional lender. The firm originated loans pursuant to USDA’s Rural Development Business and Industry program. Since First Farmers sought to use Pennant Management to finance what were claimed to be USDA guaranteed loans, the seven person firm furnished the adviser with information, including unaudited 2012 financial statements and a 2013 unaudited balance sheet through February 2013. The firm planned to originate $140 million in loans in 2013.
The adviser tasked certain employees with conducting due diligence and had a private investigator investigate the firm. While the adviser’s employees confirmed First Farmers was a USDA lender other information was not confirmed. The investigator found that First Farmers CEO was not a college graduate as claimed, had a poor credit history, pleaded no contest to assaulting a police officer, had two DUIs and had been sued multiple times for breach of contract.
Subsequently, the investment committee approved a repo facility with First Farmers with a limit of $75 million. Clients began purchasing the repos although they were not informed about First Farmers’ CEO or the unaudited financial data. Throughout 2013 and much of 2014 the investment committee continued to increase the credit limit for First Farmers until it reached $200 million in June 2014.
During the period the adviser continued to discover red flags regarding First Farmers:
· At the time the credit limit was raised in August 2013 the adviser still did not have audited 2012 financial statements, the tax return for that year or any 2013 quarterly financial statements for First Farmer although client investments had climbed to $91 million;
· In April 2014 First Farmers did furnish audited financial statements supposedly by a new auditor whose existence could not be confirmed by an adviser employee through internet searches, although when asked the lender furnished a brief statement about the firm;
· A visit to First Farmers’ Offices in July 2014 resulted in an adviser employee raising concerns about the firm with the CEO of Pennant Management; and
· A report by a second investor, commissioned after to the visit to First Farmers’ offices, determined that the underlying borrowers for several of the loans could not be located.
Throughout the period the newly retained CCO of Pennant Management – he had been a portfolio manager with no compliance experience – continually raised concerns about the inadequate staffing of the adviser’s compliance function. The CCO repeatedly expressed concern about the lack of resources and the dangers it posed. The adviser’s CEO denied repeated requests for additional resources and, to the contrary, added to the duties of the CCO.
In September 2014 the USDA confirmed to Pennant Management that a representative sample of the loans purchased from First Farmers were fraudulent. USDA declined to honor its guarantees. The adviser subsequently filed suit against First Farmers after which the FBI arrested the firm’s CEO. At that point the adviser informed its clients — they had continued to invest throughout the period — about the fraud. The Order alleges violations of Adviser Act sections 204, 206(2), 206(4) and 207.
To resolve the proceedings the adviser consented to the entry of a cease and desist order based on the sections cited in the Order and to a censure. The firm will also pay a penalty of $400,000. See also In the Matter of Mark A. Elste, Adm. Proc. File No. 3-1885 (Nov. 6, 2018)(proceeding naming the CEO of the adviser as a Respondent based on the conduct described above; resolved with a consent to the entry of a cease and desist order based on causing violations of section 206(4) of the Advisers Act, a censure and the payment of a $45,000 penalty).