Alternative Mutual Fund Found to Have Violated Custody and Brokerage Rules

February 12, 2015

The SEC brought an enforcement action against Water Island Capital LLC (Water Island), in connection with investment company custody violations.  Water Island is based in New York, New York, and manages certain alternative mutual funds (the “Funds”) with approximately $3.5 billion in assets. To carry out its strategies, Water Island trades equities and derivatives including swaps.

Section 17(f)(5) of the Investment Company Act of 1940 generally provides that if an investment company maintains its securities and similar investments in the custody of a qualified bank, the cash proceeds from the sale of such securities and similar investments and other cash assets of the investment company must also be kept in the custody of such a bank. According to the SEC, the Funds’ compliance procedures provided that each Fund “shall maintain its securities and similar investments, the cash proceeds from the sale of such securities and similar investments and other cash assets … in the custody of a qualified bank.”

The SEC found that Water Island did not ensure that certain assets of the Funds were maintained in the custody of the Funds’ qualified bank. The Funds’ broker-dealer counterparties instead held assets consisting of roughly $247 million in cash collateral. Water Island caused the Funds to post the contractually required cash collateral relating to certain total return and portfolio return swaps. Water Island, however, did not ensure the transfer of these assets to the Funds’ qualified bank as required by Section 17(f)(5) of the 1940 Act and the Funds’ policies and procedures.

The 1940 Act also governs the use of fund brokerage, or amounts used to effect portfolio securities transactions, to pay for expenses related to the distribution of fund shares. The SEC deems fund brokerage is an asset of the fund. Rule 12b-1(h) under the 1940 Act prohibits funds from compensating a broker-dealer for promoting or selling fund shares by directing brokerage transactions to that broker. Rule 12b-1(h) permits broker-dealers that provide best execution to also sell the fund’s shares. Accordingly, a fund is permitted to direct fund portfolio transactions to brokers that sell fund shares only if the fund or its adviser has implemented policies and procedures reasonably designed to, among other things, ensure that the selection of brokers for portfolio securities transactions is not influenced by considerations about the sale of shares of that or any other fund.

The SEC stated that the Funds’ policies and procedures concerning Rule 12b-1(h) were not implemented following their adoption. As required by the relevant policies and procedures concerning Rule 12b-1(h), Water Island had the responsibility for implementing the policies and procedures designed to ensure that any broker selected to execute securities transactions was chosen in accordance with the Rule. Water Island failed to create and maintain an approved list of executing brokers for the Funds pursuant to the Rule 12b-1(h) policies and procedures, and also failed to maintain documentation reflecting monitoring of the Funds’ compliance with the Rule 12b-1(h) policies and procedures, as required by the policies and procedures themselves.

As a result of the brokerage and custody arrangements, Water Island caused the Funds to violate Sections 12(b) and 17(f) of, and Rule 12b-1(h) under, the 1940 Act. The SEC also found that the Funds’ compliance procedures did not meet the requirements of Rule 38a-1 under the 1940 Act, the compliance rule, because they were not reasonably designed to prevent violations of the federal securities laws.

Click to access the enforcement action.


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