Adviser Failed to Disclose Deteriorating Financial Condition
A federal court ruled that an investment adviser and its principal violated the Advisers Act by failing to disclose its deteriorating financial condition and neglecting compliance policies and procedures. The adviser needed significant loans, including loans from clients, to fund its operations. Over several fiscal years, the firm lost money and incurred borrowings that exceeded 25% of its revenues. The firm also missed vendor, payroll, and rent payments. Yet, firm failed to add disclosure to Form ADV, Item 18, which requires disclosure of any “financial condition that is reasonably likely to impair [the adviser’s] ability to meet contractual commitments to clients.” Following an SEC exam, the firm adopted policies and procedures about documentation and disclosure of loans, but the firm failed to follow those procedures.
The SEC has become more aggressive in enforcing Item 18 financial condition disclosure. This case gives some guidance on when to add language to your ADV: loans more than 25% of revenue, successive negative net income periods, and delinquent payments of ongoing expenses. Also, the SEC will not look kindly on firms that adopt policies and procedures to respond to a deficiency letter and then fail to implement them.