(Article from Registered Funds Regulatory Update, October 2023)
For more information, please visit the Registered Funds Resource Center.
The SEC recently settled charges against ETF Managers Group LLC, a registered investment adviser, as well as Samuel Masucci, its founder, and Exchange Traded Manager’s Group LLP, its parent company. The settlement relates to alleged non-disclosure of conflicts of interest involving the ETFMG Alternative Harvest ETF, the first cannabis ETF in the United States.
Beginning in the second half of 2019, ETF Managers Group urgently needed tens of millions of dollars to settle private litigation. To secure financing, ETF Managers Group used the ETF’s lucrative securities lending revenue stream to negotiate $20 million in financing from the ETF’s custodian and securities lender, the only entity willing to provide rescue financing without which ETF Managers Group faced certain bankruptcy.
Back in 2017, when the ETF was converted to track a cannabis index, the custodian and securities lending agent for the ETF ceased serving the ETF because it was unwilling to accept the reputational and legal risk then associated with cannabis. After months of searching, the only replacement custodian that could be found was one that agreed to a 60/40 “split” of the securities lending revenue with the custodian receiving 40%, which was significantly less favorable than the ETF’s previous 80/20 split in place with its prior custodian. By early 2019, however, the number of willing service providers for cannabis funds had increased and ETF Managers Group and Masucci were able to obtain estimates for more than a half-dozen willing alternatives with more favorable splits of 70/30 or 80/20, which were more typical of similar securities lending arrangements at that time.
In the spring of 2019, ETF Managers Group and its parent lost a trial and were ordered to pay multi-millions in damages. Thereafter, Masucci began soliciting financing from various financial institutions needed to settle the litigation but the only entity willing to provide funding was the ETF’s current custodian. In August 2019, Masucci made an offer to settle the litigation, which was guaranteed by the ETF’s custodian; however, the guarantee was contingent on the ETF maintaining its securities lending business with the custodian whose 40% split of the lending revenue had earned it more than $10 million in revenues and made the ETF one of its “top 5” clients.
Masucci informed the ETF’s independent trustees of the final terms of the financing arrangement to settle the litigation but he never disclosed that it was conditioned on keeping the ETF’s securities lending business with the current custodian at a 60/40 split. Moreover, he did not disclose that other service providers had offered 80/20 and 70/30 splits. Instead, Masucci falsely represented that the current custodian remained the ETF’s only viable option because other firms remained reluctant to take the business given the continued risks associated with servicing a cannabis fund. Masucci’s failure to fully and fairly disclose these conflicts of interest occurred across regular updates to the independent trustees who Masucci knew were closely monitoring the situation given their need to protect the ETF in the event of ETF Manager Group’s insolvency.
The Order found that Masucci and ETF Managers Group violated their fiduciary duties of loyalty and care to the ETF under Sections 206(1) and 206(2), the anti-fraud provisions, of the Advisers Act and that Masucci, ETF Managers Group, and Exchange Traded Manager’s Group violated provisions set forth in Section 17(d) of the Investment Company Act and Rule 17d-1 thereunder prohibiting certain joint transactions.
Without admitting or denying the SEC’s findings, Masucci agreed to a cease-and-desist order, a $400,000 civil monetary penalty, and an associational bar under the Advisers Act and a prohibition under the Investment Company Act with a right to reapply after three years. ETF Managers Group and Exchange Traded Manager’s Group agreed to a cease-and-desist order, censures, and joint and several civil monetary penalties of $4 million.
In the Matter of Exchange Traded Managers Group LLC, et al., SEC Admin File No. 3-21542 (Aug. 1, 2023), available at: https://www.sec.gov/files/litigation/admin/2023/34-98034.pdf.