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Cady Bar the Door Insight & Commentary on SEC Enforcement Actions and Related Issues

IA Exams and Foxhall Capital Management

Posted in Compliance, Investment Advisers

Several weeks ago I discussed what I think is the great likelihood that investment advisers are about to be subject to more regular periodic exams in the coming years.  That train could get derailed – crazier things have happened – but it seems likely to me that investment advisers are soon going to have to open their books to regulators with a lot more frequency.  If you’re an investment adviser and that does happen, are you ready?  Foxhall Capital Management wasn’t.

In April Foxhall and its CEO, Paul Dietrich, settled an administrative proceeding brought by the SEC for (1) failing to have written compliance policies and procedures reasonably designed to prevent violations of the Investment Advisers Act and its rules, and (2) failing to keep complete and accurate records.  The case arose from a routine exam in 2009.  According to the SEC, here’s what happened in this pretty complicated matter:

Facts

Foxhall’s clients chose particular model portfolios but delegated discretionary investment authority to Foxhall, including the discretion to aggregate client orders into block trades.  Foxhall exercised this discretion by trading securities for all clients assigned to a particular investment strategy by placing large block trades.  Foxhall would allocate shares in the block trade among clients based on the clients’ chosen model portfolios and their account balances.  Foxhall then ordered its custodian to execute the block trades and allocated the trades to specific client accounts pursuant to Foxhall’s investment discretion and orders.

Incompatible Trading Systems

Unfortunately, Foxhall’s trade management system was not compatible with the custodian’s trading platform, and the disconnect began creating real-time trade reconciliation issues until the problems were solved by September 2009.  As a result, at times Foxhall traders did not have accurate real-time information from the custodian regarding clients’ actual current account balances when Foxhall was making initial allocations to clients for block trades.  On occasion, Foxhall reallocated shares to its clients based on inaccurate client account balance information, and some clients who were allocated to receive certain shares did not have sufficient funds to buy those shares.  Therefore, the block trades could not be allocated.

Unallocated Shares

Foxhall typically learned about unallocated shares several days after the original block trade was placed.  When the custodian encountered insufficient funds in any client account, it would alert Foxhall and ask it for guidance as to how to allocate the remaining part of the block trade.  At the time, Foxhall followed an unwritten practice to reallocate shares to only those clients who fell within the same investment model portfolio and who had enough extra cash to buy the shares.    If shares were could not be reallocated under these criteria, the unallocated shares were sold through Foxhall’s account.  As CEO, Co-CIO and CCO, Dietrich was generally aware of the trade reconciliation issues, but was not aware of the specific ways the traders handled the issues.

Reallocating the Shares

Foxhall generally directed the custodian to place the unallocated shares from the block trade into other client accounts within the same investment model that had sufficient extra cash to buy the shares being reallocated.  Foxhall reallocated these shares to clients with cash at the execution price, without considering whether the price had gone up or down since the shares were purchased.  Depending on the stock price’s movement, this practice resulted in some clients paying more (and some clients paying less) for the stock than they would have paid had Foxhall bought the shares on the open market at the time of the reallocation.  Shares that Foxhall could not reallocate to clients were sold through its error account.  Foxhall incurred a benefit when the shares had increased in value from the purchase price.

In over 400 instances, Foxhall reallocated shares to clients other than those originally intended to receive the shares.  These clients suffered approximately (approximately!) $20,183 in losses as a result of those reallocations.

Pain for Foxhall

The SEC held that Foxhall willfully violated (1) Section 206(4) of the Advisers Act and Rule 206(4)-7 for failing to implement written policies and procedures designed to prevent violations of the Act and its rules; and (2) Section 204 of the Advisers Act and Rule 204-2(a)(3) by failing to keep complete and accurate records relating to its business.  The SEC also held that Dietrich aided and abetted Foxhall’s violations.  Foxhall had to pay disgorgement of $20,183 plus prejudgment interest and a civil penalty of $100,000.  Dietrich was also hit with a civil penalty of $25,000.

In deciding to settle the matter on these terms, the Commission considered Foxhall’s remedial acts and cooperation with the SEC staff.  Specifically:

  • Foxhall changed its primary custodian in 2008 and upgraded its trading platform in 2009;
  • Foxhall and Dietrich hired a compliance consultant to perform the 2007 and 2008 annual compliance reviews and to evaluate and give guidance regarding Foxhall’s compliance practices and procedures; and
  • Foxhall also hired an independent accountant to analyze the impact of Foxhall’s reallocation process on its clients.

Foxhall’s case is pretty complex.  But if you are an investment adviser, you’re in a complex business, and the details of your trading practices will be exposed to regulators in routine exams, as Foxhall’s were here.  You’ll be wise to get yourself straight before the SEC does it for you.