While this happened in the middle of last year, we thought it might be helpful to managers to review this particular case especially as registered investment advisers are currently in the process of updating Form ADV.

Overview of Case

On June 21, 2012, the SEC filed in action in the US District Court for the Northern District of California against Mark Feathers (“Feathers”) and Small Business Capital Corp. (“SB Capital”), Investors Prime Fund (“IPF”), and SBC Portfolio Fund (“SPF”). The SEC alleges that Feathers and SB Capital made material misrepresentations and omissions regarding both IPF’s and SPF’s investment activities. Feathers and SB Capital also allegedly violated broker-dealer registration provisions and created fraudulent management fees.

The SEC alleges Feathers and SB Capital used a Ponzi-like scheme to pay returns to investors. SB Capital allegedly misrepresented the portfolios of the funds at issue, the funds’ lending standards, the nature of the funds’ loans, and the existence of conflicts of interest between SB Capital and the funds. These misrepresentations appeared in advertisements in California publications, newsletters, and offering documents. In addition, SB Capital allegedly made transfers between IPF and SPF to increase management fees. Finally, the SEC claims that SB Capital never registered as a broker-dealer.

The SEC asserted causes of action under Section 17(a) of the Securities Act (prohibiting fraudulent interstate transactions), Section 10(b) of the Exchange Act and related rules (prohibiting the use of manipulative and deceptive devices in the buying and selling of securities); Section 15(a) of the Exchange Act (prohibiting unregistered broker-dealers from inducing the trading of securities); and Section 20(a) of the Exchange Act (creating liability for the person in control of an entity which violates Section 15(a) of the Exchange Act).

The SEC’s complaint is available here.

Takeaways for Managers

The alleged conduct included the following:

• Never registering with the SEC as a broker-dealer.
• Representing that the funds’ returns would be 7.5% per year;
• When returns did not meet that threshold, using money from new investors to make up the difference;
• Failure to disclose the use of investor money to pay SB Capital’s day-to-day expenses, conduct that was in direct conflict with materials provided to investors;
• Stating that the funds would not make loans to SB Capital, when in fact they did;
• Mischaracterizing the funds’ loan portfolios as secured, when in fact they were not;
• Misrepresenting the audit procedures in place;
• Causing IPF to purchase loans at a premium from SPF to generate management fees; and
• Assuring investors SB Capital owed them a fiduciary duty, even though Feathers and SB Capital would cause the funds to engage in related party transactions to generate management fees.

The bottom line:

• Broker-dealers should register with the SEC to avoid liability under Section 15(a) of the Exchange Act;
• Be honest about the nature of the funds you manage, including the portfolios of the funds, the kinds of transactions the funds engage in, and how returns operate;
• Be upfront with investors about potential conflicts and related party transactions; and
• Take care that the materials you provide investors are accurate.

Conclusion

On the most basic level, Small Business Capital Corp. represents a warning to managers to not engage in fraudulent or exploitive conduct like taking advantage of conflicts of interest and related party transactions. More generally, it is a good reminder that providing truthful information to investors is paramount. The SEC approaches the anti-fraud provisions of the securities laws broadly. We recommend that managers have their attorney, in-house counsel or compliance consultant review all materials meant for distribution prior to distributing them, and that managers retain these materials and backup information in their files.

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Cole-Frieman & Mallon LLP provides a full suite of legal and advisory services to hedge fund managers and the investment management industry.  Bart Mallon can be reached directly at 415-868-5345.