Untested, Error Ridden Models Yield $97 Million SEC Settlement
The Commission’s focus on retail investors met with the public’s fascination with all things high tech in the agency’s newest action involving four affiliates of the Transamerica firm. Those entities were involved with nine different products and strategies created by an inexperienced developer that were launched without substantial testing. The errors inherent in such a process were largely ignored while the inexperienced developer was kept out of sight. In the end, however, the four affiliates paid $97 million based on violations of various provisions of the federal securities laws to resolve the actions. In the Matter of Aegon USA Investment Management, LLC, Adm. Proc. File No. 3-18681 (August 27, 2018).
The Order names as Respondents: AEGON USA Investment Management or AUIM, a registered investment adviser that is a subsidiary of Aegon N.V, a multinational insurance and asset management company based in the Netherlands. Also named as Respondents are affiliates: Transamerica Asset Management, Inc. or TAB, a registered investment adviser; Transamerica Capital, Inc. or TCI, a registered broker-dealer; and Transamerica Financial Advisors, Inc. or TFA, a dual registered investment adviser and broker-dealer.
Nine different products and strategies were involved: Transamerica AEGON Active Asset Allocation – Conservative VP Portfolio, Transamerica AEGON Active Asset Allocation – Moderate VP Portfolio, Transamerica AEGON Active Asset Allocation – Moderate Growth VP Portfolio, Index 35 VP Portfolio, Index 50 VP Portfolio, Index 75 VP Portfolio and Tactical Allocation Fund; each is a series of Transamerica Funds and an open-ended mutual fund.
In 2010 AUIM instructed an analyst with an MBA and no portfolio management experience or formal training in modeling to develop quantitative models for use in managing investment strategies. By the next year AUIM had identified potential risks associated with using models to manage third-party assets. By late 2011 however, it had not reviewed the models created for accuracy or formally validated them.
Nevertheless, AUIM decided to launch a new product, the TTI Fund, before its model had been finalized and validated. An internal warning regarding the lack of testing was ignored. Rather a peer review process was employed. That process exposed several glaring errors. While those were corrected no further testing was used. To the contrary, AUIM launched each of the products and strategies without taking the steps necessary to confirm that the models worked as intended. AUIM’s parent did have a policy requiring that its firms test models, but it was not followed.
Respondents TAM, TCI and TFA knew the models were launched without taking the proper steps to confirm them. Nevertheless, marketing materials were created noting that the products were model driven, eliminating emotions and the emotional bias. In contrast the prospectuses for the products did not reference the models or disclose the risks associated with their use. The inexperienced analyst who created the products was not disclosed.
TAM and AUIM stated in filings made with the Commission that the primary objective for one of the Products was high current income with a goal of consistent monthly dividend that ranging from 4% to 7%. The dividend would be calculated based on estimates of expected dividends from the fund’s holdings. Neither TAM nor AUIM determined if the Fund’s holdings could support such a dividend. In fact most of the initial dividends were attributed at least in part to an estimated return of investors’ capital. Several of the payments actually came from a return of capital.
TAM and AUIM also added volatility guidelines to the variable life insurance and variable annuity investment portfolios in 2011. Under certain market conductions the overlays could reduce their exposure to the equity markets below the stated target percentages, a fact not disclosed. Two years later the error was discovered. TAM disclosed the error; AUIM did not.
During the summer of 2013 AUIM concluded that its allocation models used to manage the TTI Fund and AAA Portfolios contained material errors. The firm determined that one asset allocation model was not fit for its purpose. AUIM halted the use of that model but failed to inform the board. Ultimately over 50 errors were discovered in certain AUIM models used to manage the Products and Strategies. TAM and TCI learned of the errors. Rather than disclose these facts the prospectuses were revised to state that they “may” be using a proprietary quantitative model. Ultimately TAM terminated its Investment sub-advisory agreement with AUIM. That firm terminated its model manager agreement with TFA in April 2015.
The Order alleges violations of Securities Act section 17(a)(2) and Advisers Act sections 204, 206(2) and 206(4). To resolve the proceedings each Respondent consented to the entry of a cease and desist order and a censure: AUIM based on sections 17(a)(2), 206(2) and 206(4); TAM on sections 206(2), 206(4); TCI on section 17(a)(2); and TFA on 204 106(2) and 206(4). Collectively respondents paid $97,602,040 in penalties, disgorgement and prejudgment interest. See also In the Matter of Bradley J. Beman, Adm. Proc. File No. 3-18682 (August 27, 2018)(proceeding naming as Respondent the Global CIO for AUIM and based on the same conduct; resolved with a consent to a cease and desist order based on Advisers Act section 206(4) and the payment of a $65,000 penalty); In the Matter of Kevin A. Giles, Adm. Proc. File No. 3-18683 (August 27, 2018)(proceeding naming as Respondent AUIM’s Director of New Initiatives during the period; resolved with a consent to the entry of a cease and deist order based on Advisers Act section 206(4) and the payment of a $25,000 penalty).