SEC Sues Adviser for Failing to Disclose Financial Condition
The SEC has filed suit against an investment adviser that failed to disclose its poor financial condition in its Form ADV. According to the SEC, the respondent suffered significant financial strain resulting from litigation with minority shareholders. During roughly the same period, assets under management declined from over $7 Billion to $1.44 Billion. The SEC charges that by September 2011, the firm had (i) liabilities exceeding its assets (resulting in negative shareholder equity), (ii) a $2.7 Million operating loss, and (iii) significant creditors (including a $2 Million tax lien). However, in its September 2011 ADV filing, the firm responded “N/A” to Item 18, which requires disclosure of any financial condition that is reasonably likely to impair a firm’s ability to meet contractual commitments to clients. The firm ultimately filed bankruptcy. The SEC separately charged the respondents with conducting a cherry-picking scheme whereby it allocated profitable options trades to client and insider accounts.
OUR TAKE: Many financially-struggling firms wrestle with when to make Item 18 disclosure. According to this case, consider disclosure when one or more of the following situations arise: significant litigation, creditor liens, a rapid decline in AUM, negative shareholder equity, and/or material operating losses.