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Regulation and Compliance > Federal Regulation > SEC

Series Trusts Are in SEC's Exam Crosshairs

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As the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations closes in on series trusts as an examination priority this year, now is the time for series trust investment advisors to circle the wagons to fortify their compliance programs.

Weak board oversight and cellophane compliance have tarnished the reputations of several series trust and fund managers. The SEC has focused on risk controls, disclosures and process when scrutinizing firms for potential wrongdoing.

Series trust sponsors should take a moment to consider not just how to attract new managers but how to protect their current clients and their brands with an active board and an independent compliance program.

A series trust is a rent-a-trust for advisors who want to start a registered fund but don’t want to do all the back office.

Generally, the series trusts are sponsored by fund administrators that offer a packaged group of services including the Board, fund accounting, distribution, compliance, and transfer agency.  They are very popular with advisers testing the waters with their first fund product.

In its administrative proceedings relating to series trusts, the SEC has focused on the board oversight process. On Jan. 27, the SEC fined Catalyst Capital Advisors over $10 million to settle charges that it failed to run a mutual fund according to the risk disclosures in the fund’s prospectus and marketing materials.

While the fund’s registration statement disclosure and marketing materials disclosed strict risk management procedures to mitigate downside risk, the fund exposed investors to a high risk of loss of capital through large option contracts that operated to short the S&P 500 Index. The SEC alleged that the respondent lied to the board about how it would implement risk controls.

Subsequently, the fund’s investors suffered hundreds of millions of dollars in losses directly stemming from the undisclosed risks, with the value of fund assets plummeting over $1 billion in the first few months of 2017. Although the SEC did not charge the board members, the Catalyst case raises the bar for independent directors to not just get assurances but to also ensure promises are kept.

Large investor losses prompted an earlier SEC administrative action relating to a series trust in the Team Financial case. Rather than an error of commission, the SEC alleges an error of omission by the investment advisor that failed to inform the board that certain derivative investments would constitute part of the fund’s principal investment strategy.

Accordingly, prospectus disclosures were not sufficient, and shareholders were caught unaware when fund performance hemorrhaged due to heavy speculative derivatives investments and the fund was later liquidated. Again, should the board have taken bolder action to determine that the fund incurred more risk than represented?

The cornerstone of a strong series trust offering is an independent compliance function that can provide the board with a comprehensive assessment about a proposed advisor’s risk management program.

The board is only protected when it seeks, and receives, complete information from an independent chief compliance officer. In a case against Northern Lights Compliance Services, the SEC alleged that the series trust sponsor gave short shrift to the reviews of advisor compliance programs and failed to provide the board with full information.

Minutes should be carefully tailored to reflect the considerations applicable to each manager’s business, including the factors evaluated in the annual 15(c) advisory contract renewal process.  Peer groups for performance comparisons should be appropriate, and profitability information should be sufficient for the board to assess.

Above all, information provided to boards must be accurate and board approval should be sought for, among other matters, any material investment strategy changes.

Series trust investment advisors must heed the bellwether of OCIE’s 2020 Exam Priorities and seek to enhance their compliance policies and procedures as needed before the SEC staff shows up at their doorstep.

Key takeaways for series trust advisors from SEC Administrative Proceedings since 2013 include:

  1. Boards should receive all information they reasonably request to perform their duties;
  2. Minutes and advisory contract renewal disclosure in shareholder reports cannot be boilerplate and should be tailored to board discussions;
  3. Shareholder reports must include advisory contract renewal disclosure when required;
  4. All board materials should be accurate and sufficient for the board to meet its responsibilities and all materials should be retained, including adviser financial information;
  5. Board approval of material investment strategy changes should be obtained, reflected in registration statements and marketing materials and adhered to by portfolio managers; and
  6. Compliance with principal investment strategy disclosure should be strictly monitored.

Series trust sponsors and fund advisors should spend some time to review Board practices and compliance procedures. Otherwise, any growth will be offset by regulatory entanglements that could have long-lasting effects.

Todd Cipperman, Esq., is the founding principal of Cipperman Compliance Services, a CCO outsourcing firm based in Wayne, Pennsylvania.  Before founding CCS over 15 years ago, Todd was General Counsel at a fund management company and worked in private practice.

Dianne Descoteaux, Esq., is compliance director at Cipperman Compliance Services. Dianne is an experienced investment management attorney who spent nearly 10 years at SEI Investments following several years in private practice at major law firms. She focuses on fund and adviser regulatory issues.


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