News & Articles

Gatekeeper failures in recent enforcement action raises potential of additional regulation

In June 2016, a U.S. based fund administrator (referred hereto as “ABC Fund Administrator” for anonymity), was charged with gatekeeper failures for neglecting to heed red flags and correct faulty accounting for two of its clients, both of which have since been charged with fraud by the SEC. ABC Fund Administrator settled with the SEC for $350,000.

By providing accurate reporting of fund assets, administrators serve an important gatekeeper function for the alternative investments industry. In this instance, however, ABC Fund Administrator failed to fulfill its gatekeeper responsibilities by ignoring red flags that were related to their contractual duties, and enabling their clients’ fraud by not taking appropriate actions after discovering them. Red flags included undisclosed brokerage and bank accounts, undisclosed margin and loan agreement, transfers made in violation of fund offering documents, misrepresentation of withdrawals, and other indicia of the misappropriation of assets. In their failure to take reasonable steps after discovering these red flags, ABC Fund Administrator enabled their clients’ fraud by continuing to prepare inaccurate statements that were sent to investors.

Because of this, the SEC determined that ABC Fund Administrator was a cause in their clients’ violations of Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-8 thereunder. Section 206(2) prohibits investment advisers from engaging in any transaction which operates as a fraud or deceit upon clients or prospective clients. Section 206(4) and 206(4)-8 make it unlawful for investment advisers to a pooled vehicle to make untrue statements of material fact or to omit the statement of material facts necessary to make the statements not misleading to any investor or prospective investor in the pooled investment vehicle.

Previous Administrator Liability

In the United States, regulatory enforcement actions against fund administrators have been uncommon, but past SEC charges against fund administrators appear to center on compliance and recordkeeping violations.[1] The ABC Fund Administrator Order seems to indicate regulatory intent to expand gatekeeper responsibilities, and may be the first step in the path towards regulating fund administrators.

Civil claims against fund administrators have centered around the issues of gross negligence, misrepresentation, and breach of fiduciary duty.[2]  In the civil claims, administrators’ gatekeeper liability and duty to investors has largely been limited by their contractual obligations with funds, under which the scope of services are varied.

Path Towards Regulation?

Overseas, fund administrators are already regulated. In the United Kingdom, fund administrators are regulated and must be authorized by the Financial Conduct Authority. In Ireland, fund administrators are authorized and supervised by the Central Bank of Ireland. In Bermuda, fund administrators are regulated under the Investment Funds Act 2006. In addition, overseas administrators are expected to implement best practices and are subject to various reporting requirements.

With intensifying scrutiny on the alternative investments industry and growing need for fund administrators, greater responsibility has been placed on administrators in middle-office support, reporting, and risk management functions. However, in light of the ABC Fund Administrator enforcement action, it follows that administrators will also need to adapt to expanded gatekeeper duties.

Given the current regulatory environment and the fact that fund administrators are already largely regulated overseas, U.S. regulators may follow suit and sweep administrators under their purview, especially in the event of mounting concerns over gatekeeper failures.

[1] In the Matter of Morgan Stanley Investment Management Inc., available at: <https://www.sec.gov/litigation/admin/2011/ia-3315.pdf>; In the Matter of Deloitte & Touche, LLP, ALPS Fund Services, Inc., and Andrew C. Boynton, available at: <https://www.sec.gov/litigation/admin/2015/34-75343.pdf>

[2] Bradshaw v. Maiden, 2015 NCBC 76.