(Article from Registered Funds Regulatory Update, July 2024)
For more information, please visit the Registered Funds Resource Center.
The SEC settled charges against a Puerto Rican-based registered investment adviser for entering into an impermissible joint arrangement with its client, an SEC-registered open-end investment company, resulting in the RIC temporarily paying a disproportionately high amount of legal costs.
According to the Order, the RIA improperly arranged for the RIC to pay, at least initially, the legal fees and expenses associated with regulatory inquiries and private litigation following significant losses of a series of the RIC relating to an options trading strategy between December 2016 to February 2017. The Order stated that the RIA and RIC received SEC and other regulatory inquiries starting in February 2017 related to the RIC’s losses, and were involved in an April 2017 class action and an August 2017 shareholder derivative action.
The RIA and RIC retained the same legal counsel to represent them in these matters, incurring legal expenses that amounted to $2.7 million. While the engagement letter acknowledged that conflicts of interest might arise between the RIA and the RIC, it failed to address how fees and expenses would be allocated between the RIA and RIC, including when legal services were rendered simultaneously to both entities. Moreover, the invoices did not delineate between the fees and expenses of the RIA versus the RIC.
The RIC maintained an insurance policy, subject to a deductible and a ceiling, to cover legal fees whereas the RIA did not. Because the regulatory inquiries and litigation involved overlapping facts and legal issues affecting both the RIA and the RIC, and to maximize coverage under the insurance policy, the RIA arranged for the RIC to pay all of the legal fees in connection with the regulatory inquiries and litigation, which were subsequently submitted under the RIC’s insurance policy for repayment. According to the RIA, it planned to reimburse the RIC later for the fee amounts that the insurance provider determined were not properly allocable to the RIC and that would not be covered under the policy. Consistent with this, the RIA paid the RIC’s portion of a private settlement and accounted for additional legal costs before the commencement of the SEC’s investigation. However, neither the RIA nor the RIC disclosed the fee arrangement to the RIC’s independent trustees. They also did not submit an application to the SEC seeking relief for the joint arrangement between the RIA and the RIC that would have otherwise been prohibited under the Investment Company Act. The Order found that the RIA benefitted from the impermissible joint arrangement by, among other things, deferring payment of its legal bills for multiple years.
Without admitting or denying the SEC’s findings, the RIA consented to a cease-and-desist order, a censure, and agreed to pay disgorgement of $280,902, of which $183,757 was offset by a previous payment to the RIC, prejudgment interest of $30,081, and a civil monetary penalty of $200,000.
In the Matter of Catalyst Capital Advisors LLC, SEC Admin. File No. 3-21923 (Apr. 29, 2024), available at: https://www.sec.gov/files/litigation/admin/2024/ia-6597.pdf.