The SEC recently announced a settled enforcement action against a hedge fund manager (who was also a registered adviser) alleging that the manager fraudulently took securities for itself that its hedge funds had purchased. Although the case may be viewed simply as another misappropriation matter, a closer look at the alleged facts and legal analysis relied on by the SEC suggest important lessons and potentially interesting developments. See In the Matter of M.A.G. Capital, LLC, Advisers Act Release No. 2849 (Mar. 2, 2009), available at http://www.sec.gov/litigation/admin/2009/ia-2849.pdf.  

According to the SEC settlement order, the manager’s funds purchased warrants and other securities in PIPE transactions. On forty-four separate PIPEs transactions between May 2003 and September 2006, the manager took a portion of the warrants in each transaction, but did not compensate the funds for the warrants that it took. The SEC settlement order further stated that during a substantial period in which the manager engaged in the alleged activities, the funds’ PPMs generally disclosed that “in connection with financing a Portfolio Company, the Partnership and the General Partner may receive warrants to purchase common stock of the Portfolio Company.” The SEC stated that this disclosure was inadequate because it did not disclose that the warrants the manager took were being paid for by the funds and that the manager was not compensating the funds for the warrants.  

The alleged violations came to light during a routine SEC examination. According to the SEC settlement order, the SEC examination staff brought its concerns to the attention of the manager during an interview outlining deficiencies found during the examination. In response to the concerns, the manager revised its PPM disclosures and sent the revised PPM to investors along with a cover letter highlighting the changes. The revised disclosure stated, in bold, that with respect to due diligence fees, “the amount of the due diligence fee may be payable in the form of cash, warrants to purchase common stock of the Portfolio Companies or other securities.” The revised disclosure also stated that, with respect to fees for possible post-investment activity, the manager:  

may receive a fee, typically payable in the form of cash, or warrants to purchase shares of Portfolio Company stock or other securities, for the possible provision of the [post-investment] activities described above. Such fee, if any, may be charged either concurrent with an investment in a Portfolio Company or subsequent to such investment, at [the manager’s] discretion. Such fee, if received in the form of warrants, is designed to incentivize [the manager] to maximize the value of the underlying stock in the Portfolio Company. The exercise price of warrants typically will be greater than the fair market value of the underlying stock at the time of receipt of such warrants.  

The SEC stated that this revised disclosure was also inadequate. Specifically, the SEC noted that the revised disclosure still failed to alert the funds that the warrants the manager took were being paid for by the funds and that the manager was not compensating the funds for the warrants.  

Based on these allegations, the SEC determined that the manager breached its fiduciary duty to the funds in violation of Section 206(2) of the Advisers Act. The SEC also determined that the manager’s principal and sole owner aided and abetted the manager’s violations. The SEC, the manager and its principal agreed to a settlement in which the manager and its principal consented to cease and desist from future violations of Section 206(2), a censure, and fines of $100,000 and $50,000, respectively. In determining the sanctions, the SEC considered remedial acts promptly undertaken by the manager and its principal and the cooperation afforded the SEC staff.  

Analysis  

A close examination of the facts alleged by the SEC and the legal analysis provided in the settlement order suggests some potentially important lessons and insights for hedge fund managers.  

  1. Disclosure Adequacy. In situations where a manager takes any form of direct or indirect compensation from a client, the manager must provide complete and detailed disclosure. In addition, and as observed in other enforcement actions over the years, the SEC tends to find that almost any amount of disclosure is insufficient if the underlying activity involves any form of overreaching.
  1. Focus on Disclosure in Private Placement Memoranda. The SEC based its case primarily on a lack of adequate disclosure in the funds’ PPMs, which was first identified by the SEC examination staff. This development suggests that the SEC examination staff is taking a closer look at the content and quality of PPM disclosures. As a result, hedge fund managers should carefully evaluate all forms of potential compensation, as well as all other potential conflicts of interest, and ensure the adequacy of related PPM disclosures.
  1. No Discussion of Form ADV Disclosures. Historically, the SEC has brought enforcement cases involving inadequate disclosures based on an adviser’s Form ADV Part II. In this instance, the SEC made no mention of the manager’s Form ADV Part II. The SEC’s sole reliance on disclosures in the fund PPMs may signal a view by the SEC that fund investors are not advisory clients and therefore a manager is not required to provide the Form ADV Part II to fund investors. If so, the SEC may have concluded that it could not bring a case based on Form ADV disclosures.  
  1. No Breach of Duty to Fund Investors. In this instance, the SEC settlement order stated that the manager breached its fiduciary duty to the funds, but did not mention any breach of fiduciary duty to the fund’s investors. The reliance on misrepresentations to the funds, rather than to investors, may signal the SEC’s acceptance of language contained in Goldstein v. SEC in which the Court of Appeals stated generally that an adviser owes a fiduciary duty to its funds, but not to the funds investors (albeit in dicta).  
  1. Use of Section 206(2), Rather than Rule 206(4)-8. The SEC alleged that the manager violated Section 206(2) of the Advisers Act, the non-scienter anti-fraud provision. The SEC did not allege a violation of Rule 206(4)-8 which generally makes it unlawful for an adviser to a pooled investment vehicle to make any untrue statement of a material fact or to omit a material fact to any investor or prospective investor in the pooled investment vehicle. Two potential reasons could explain the SEC’s rationale for not using Rule 206(4)-8. First, the manager may have considered a violation of Section 206(2) more palatable and negotiated the settlement to provide only for a violation of Section 206(2). Second, and perhaps more likely, Rule 206(4)-8 was adopted by the SEC in August 2007, almost a full year after the alleged conduct ceased. The SEC may have determined that it could not retroactively apply the rule to prior conduct. Regardless of the actual rationale, the SEC’s use of Section 206(2) supports the view of many commenters who suggested that Rule 206(4)-8 was unnecessary. Those commenters noted that, if the SEC found fraudulent conduct involving hedge fund managers and their funds, the SEC could simply rely on the existing anti-fraud provisions of the Advisers Act which apply to both registered and unregistered advisers.