Adviser Charged with Engaging in Prohibited Principal Trades through Its Affiliated Broker-Dealer with Clients

September 18, 2014

The SEC brought an enforcement action against Strategic Capital Group, LLC (SCG), an investment adviser based in Gig Harbor, Washington, for engaging in more than 1,100 principal transactions through its affiliated broker without providing requisite disclosures to clients or first obtaining their consent. The SEC also found violations related to placing trades with an affiliated broker-dealer, presenting false and misleading performance advertisements and the firm’s CCO failure to prevent such violations.

Principal Trades Violation

The SEC found that beginning on May 3, 2011, SCG engaged in hundreds of securities transactions with advisory clients on a principal basis through its affiliated registered broker-dealer, RP Capital, LLC (RP Capital), without providing prior written disclosure to, or obtaining consent from, the clients. SCG’s compliance manual defined “principal transactions” to mean “transactions where an adviser, acting as principal for its own account or the account of an affiliated broker-dealer, buys from or sells any security to any advisory client.” The manual also stated that: “principal transactions by advisers are prohibited unless the adviser (1) discloses its principal capacity in writing to the client in the transaction; and (2) obtains the client’s consent to each principal transaction.” The manual next stated that it was SCG’s policy to “NOT engage in any principal transactions.”

The SEC stated that RP Capital purchased fixed-income securities from other broker-dealers and then resold them at a higher price to SCG clients without SCG disclosing for more than a year that it was acting as principal through RP Capital and without obtaining required transaction-by-transaction consent. In addition, in its Forms ADV Part 1A filed in 2012 and 2013, SCG incorrectly stated that neither it nor any related person engaged in principal transactions.

Separately, from approximately August 2010 to March 2011, the SEC found that SCG provided prospective clients advertisements that contained false and misleading claims and disclosures about the performance of SCG’s investment model. The advertisements were also publicly available on SCG’s website for at least a month. In the advertisements, SCG claimed the performance returns portrayed were “historical” for SCG’s investment model when, in fact, the majority of the results were hypothetical because they were based in part on the use of indexes rather than SCG’s actual investment recommendations.

As a result of the conduct described above, the SEC found that SCG willfully violated Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction, practice, or course of business which operates as a fraud or deceit upon a client or prospective client. Proof of scienter is not required to establish a violation of Section 206(2) of the Advisers Act but, rather, may rest on a finding of simple negligence. SEC v. Steadman, 967 F.2d 636, 643 n.5 (D.C. Cir. 1992) (citing SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 195 (1963)).

As a result of the conduct described above, the SEC found that SCG additionally willfully violated Section 206(3) of the Advisers Act, which prohibits an investment adviser from, directly or indirectly, “acting as principal for his own account, knowingly to sell any security or to purchase any security from a client . . . without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.”

Best Execution Violation

The SEC found that SCG failed to seek best execution for its clients because it failed to evaluate unaffiliated broker-dealers when selecting brokers. It also failed to adequately monitor RP Capital’s execution of fixed-income trades for clients of SCG. SCG’s policies and procedures manual stated that the firm “has a fiduciary and fundamental duty to seek best execution for client transactions.” The manual also stated that SCG’s Investment Committee had “responsibility for monitoring our firm’s trading practices, gathering relevant information, periodically reviewing and evaluating the services provided by broker-dealers, the quality of executions, research, commission rates, and overall brokerage relationships, among other things.” Also, Part 2A of SCG’s March 2012 Form ADV stated that SCG may recommend the use of RP Capital “provided SCG can meet its fiduciary obligation of best execution.”

The SEC stated that in 2010, SCG executed client trades through a registered representative of a smaller broker-dealer. In 2011, that registered representative became associated with RP Capital and, at that time, SCG began executing fixed-income transactions with RP Capital. The SEC noted that SCG also failed to seek best execution in determining to route its clients’ fixed-income transactions to RP Capital. The SEC also found that SCG failed to evaluate similar, but unaffiliated, broker-dealers to determine whether they could provide SCG clients better execution nor implement the above referenced compliance procedures to monitor and periodically review RP Capital’s execution of fixed-income transactions for SCG clients.

Performance Advertising Violation

In August 2010, the SEC stated that SCG created two advertisements that were false and misleading, and failed to document approval of them. The first advertisement claimed to show the purported “historical” performance of its model investment allocation (Company Profile). The second advertisement described purported historical returns of its equities model (SCG Equity Investments). An SCG financial analyst calculated the performance data for both advertisements, and the analyst and a compliance officer drafted disclosures that were included in them. The advertisements were disseminated to potential clients in “intro kits” used to market SCG’s services to prospective clients. For a period of at least a month, the advertisements were also publicly available on SCG’s website.

The Company Profile contained purported historical performance numbers for 1998 through 2011. The March 31, 2011 Company Profile claimed that SCG’s model achieved a 220.79% return compared to a 60/40 S&P and bond mix return of 64.57% during the period. The performance results in the Company Profile were compiled from several sources, but the SEC stated that a majority of those sources did not include actual SCG client performance.

The results portrayed in the Company Profile were purportedly calculated, in part, based on SCG’s allocation of a portion of its model portfolio to a municipal bond ladder. But the SEC found that the Company Profile did not disclose that the returns for the municipal bond ladder portion of the Company Profile were based on the returns of an index, and not the actual, historical returns achieved by SCG’s recommendations during the specified period. Nor did the Company Profile disclose that the index data did not reflect mark-ups, mark-downs, or other transaction costs that ordinarily would be incurred.

A portion of the model portfolio described in the Company Profile was allocated to a hedge fund of funds that an adviser affiliated with SCG managed. Although the fund of funds was created in 2003, the Company Profile disclosure stated that “results for the period of January 1, 1998 through June 30, 2003 are based on the historical returns and weightings of our underlying Fund Managers.” According to the SEC, this statement was false. In fact, the 1998 and 1999 returns were compiled using a hedge fund index, which reported returns of 16.95% and 20.33%, respectively, for those years. The SCG Equity Investments advertisement did not disclose that the results portrayed were gross of fees, and thus did not reflect the impact of SCG’s advisory fees on the performance results advertised. The SEC stated that this omission caused the SCG Equity Investments advertisement to materially overstate the performance of SCG’s model equity portfolio.

As a result of the conduct described above, the SEC found that SCG willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-1(a)(5) thereunder. Section 206(4) prohibits investment advisers from engaging in “any act, practice, or course of business which is fraudulent, deceptive or manipulative,” as defined by the SEC by rule. Rule 206(4)-1(a)(5) thereunder makes it unlawful for any registered investment adviser, directly or indirectly, to distribute an advertisement which contains any untrue statement of a material fact, or which is otherwise false and misleading.

CCO Violations

The SEC noted that SCG’s compliance manual contained policies and procedures that were reasonably designed to prevent SCG’s several violations of the Advisers Act. For example, the manual prohibited principal transactions, including through an affiliated broker-dealer. The manual also set forth procedures for analyzing and monitoring best execution and contained detailed procedures for approving advertising, including initialing and dating of approved materials. Yet the SEC found that SCG failed to implement these policies and procedures. The SEC stated that by failing to carry out his responsibility as Chief Compliance Officer to implement these policies and procedures, SCG’s CCO caused SCG’s compliance failures.

As a result, the SEC found that SCG willfully violated, and its CCO caused SCG’s violations of, Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which, among other things, makes it unlawful for any registered investment adviser to provide investment advice to clients unless it implements written policies and procedures reasonably designed to prevent violation, by the adviser and its supervised persons, of the Advisers Act and the rules that the SEC has adopted under the Act. A violation of Section 206(4) and the rules thereunder do not require scienter. Steadman, 967 F.2d at 647.

Furthermore, SCG willfully violated, and its CCO caused SCG’s violations of, Section 207 of the Advisers Act, which makes it unlawful for any person willfully to make any untrue statement of a material fact in any registration application or report filed with the SEC, or willfully to omit to state in any such application or report any material fact which is required to be stated therein.

Among other sanctions, SCG was ordered to pay disgorgement in the amount of $368,459 and a civil penalty in the amount of $200,000. Its CCO was ordered to pay a civil penalty of $50,000.

Click here to access the enforcement action.


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