NEW YORK (Thomson Reuters Regulatory Intelligence) - When financial services firms consult outside counsel on a potential conflict of interest, they cannot hold back information relevant to their inquiry and must be sure to ask about disclosure obligations, lest they risk unwanted regulatory scrutiny or penalties.
The Securities and Exchange Commission (SEC) recently settled(here) with California-based advisory firm Sagent Wealth Management and its majority owner, Marshall Eichenauer, Jr., in a case that illustrates why full disclosure to attorneys is important.
Sagent and Eichenauer were charged with failing to obtain client consent and failing to disclose loan transactions involving the use of fund dollars to finance loans benefiting Eichenauer. Although he asked a lawyer about the loans, he never disclosed facts that would have alerted his lawyer of potential conflicts of interest, and thus he failed to receive or seek advice on how to disclose the conflicts to clients.
Eichenauer thus invited scrutiny by the SEC, which found that that his withholding of such material facts and the absence of appropriate disclosure to clients merited a civil money fine and disgorgement.
Sagent was owned 80 percent by Eichenauer who founded it in September 2010 when he replaced a former firm he had owned with Sagent. The other 20 percent was owned by Sagent private Investment Fund I (SIPF), a private investment fund also formed by Eichenauer. In addition to being in charge of Sargent, Eichenauer was in charge of a management entity that controlled SPIF.
According to the SEC, Eichenauer’s compensation came in three parts: advisory management fees of 1.25 percent from SPIF, based on the amount of SPIF assets under management; an annual distribution of $450,000 quarterly installments, and, beginning in July 2012, an annual salary of $1 million paid by Sargent.
The arrangement did not operate as planned, as the SEC points out in its cease and desist order. “In 2011 and 2012, Sargent did not generate enough revenue to make Eichenauer’s distribution payments for his 80 percent stake in Sargent,” the agency said.
”Eichenauer relied on those payments, particularly before July 2012, as his salary did not begin until that point.
So, starting in March 2012, Eichenauer sold large portions of SPIF’s publicly-traded securities “and loaned the proceeds to Sagent so Sagent could, in turn, pay at least a portion of Eichenauer’s distribution payments,” the Commission said.
The loans were issued in five promissory notes that Eichenauer personally executed on both SPIF’s and Sargent’s behalf, the SEC said. The first was issued in March 2012 for $200,000. “Sargent initially borrowed $125,000 of that principal amount, and then borrowed the balance in four separate installments by September 2012,” according to the order.
Following that, Eichenauer executed four promissory notes, the SEC said. Those were: $50,000 in September 2012, $50,000 in December 2012, $25,000 in December 2013, and $25,000 inn January 2015.
Sagent then allegedly borrowed an additional $126,650 against those four notes, which the agency said Eichenauer continued to finance by selling SPIF’s publicly-traded securities.
“In all, between March 2012 and January 2015, SPIF loaned Sagent a total of $326,650, eventually reducing SPIF’s publicly-traded securities to less then $1,000 by January 2015,” the agency charged. “Eichenauer personally received approximately half of the loan proceeds, or $166,400, during that period.”
The SEC alleged that Sagent and Eichenauer failed to:
-- Disclose Eichenauer’s conflict of interest to SPIF investors in causing SPIF to use the fund’s publicly-traded securities to lend Sagent money, the primary purpose of which was so Sagent could make distribution payments to Eichenauer.”
-- Seek or obtain consent from the advisory clients who had invested in SPIF before causing the fund to make loans to Sagent.
-- Provide written disclosure to other SPIF investors or give them the chance to consent to the loans.
-- Appoint an independent representative or independent board to act on behalf of SPIF before the fund made the loans to Sagent.
-- Seek or receive legal advice on whether or how to disclose Eichenauer’s conflict of interest. The only legal advice sought, the SEC noted by Eichenauer, was whether the consent of SPIF’s investors was required before SPIF made the loans, given his conflict of interest.
-- Inform SPIF investors that the fund was making the loans until after SPIF’s March 2012 loan of $125,000 to Sagent. After that, according to the SEC’s order, SPIF investors were informed about the loan in quarterly updates, and the SEC said it found these inadequate.
Examiners from the Commission’s Office of Compliance Inspections and Examinations visited Sagent in May 2016.
During their examination, Eichenauer and Sagent liquidated and closed SPIF. Sagent repurchased SPIF’s 20 percent equity ownership in Sagent at the original purchase price of $900,000. Sagent then repaid the balance of SPIf’s loans to Sagent in the amount of $315,000. Afterwards, Eichenauer paid SPIF’s final expenses and closing audit, then he distributed the net proceeds to SPIF investors and terminated SPIF.
Despite these changes, the SEC notes in its order against Sagent and Eichenauer, from March 2012 to SPIf’s closure in May 2016, SPIF paid Eichenauer or Sagent $15,380 in advisory management fees for managing the loans that Eichenauer and Sagent failed to disclose and that posed a conflict of interest.
In its settlement order, the Commission found that Eichenauer and Sagent violated Adviser Act Section 206(2)(here), which prohibits fraud; 206(3), which prohibits principal transactions without disclosure; and Section 206(4) and its Rule 206(4)-8(a)(1)(here), which prohibits advisers from making untrue statements of material fact.
Both the business and Eichenauer were censured and agreed to pay a civil money penalty of $165,000 and disgorgement of $15,380.
Sagent was ordered to retain an independent compliance consultant to conduct a comprehensive review of Sagent’s current policies, procedures, and systems with respect to disclosure, custody and compliance. This consultant must conduct an annual reviews for two years after the date of the issuance of the consultant’s first report to assess the extent and effectiveness of Sagent’s efforts in implementing the recommended changes or improvements.
The disclosure and conflicts of interest problems in this case are rampant. There was no sign of controls on Eichenauer’s actions as the owner/principal of Sargent and the top executive and controlling person of the management firm controlling the private investment fund.
This was the first problem. If Eichenauer cared about nothing more than appearances, setting aside the multiple compliance obligations, he would have sought not only an attorney for answers to specific questions, he would have had a compliance professional reviewing his communications to clients.
His questions to an attorney indicated suspected a need for consent on the SPIF loans, but he never considered what type of language must go into private fund documents regarding the loans and actually seeking that consent from investors.
It is not the province of attorneys to follow up on the work of their clients unless asked; instead, they are retained to perform specific services. Although the attorney was asked whether consent was needed, it is the firm’s responsibility to initiate a request for written consent from investors.
Also, a firm and its founder may ask an attorney about conflicts of interest, but if the attorney confirms the existence of conflicts, it is up to the firm to take the next step and disclose them to stakeholders.
The advice of counsel is not a defense to one’s failure to comply with regulatory obligations; instead, such advice is generally just used to assess the state of mind of a certain party being investigated or charged.
Meaning, if someone receives legal advice that certain conduct is permissible, that advice could undercut a claim that the person acted with intent or in bad faith in following it. It does not, however, exonerate a person or firm from violating the rules and laws to which they alone are subject as covered entities and persons.
The SEC’s order notes that the legal advice sought by Eichenauer concerned only whether consent was needed to SPIF investors, not the disclosure needed to meet regulatory expectations.
Since there was no legal advice regarding disclosure, there was no way Eiuchenauer could try to use the attorney’s advice as a defense in the case.
In terms of the disclosure failures, the SEC found that the quarterly reports made to SPIF were insufficiently timely to enable investors to make informed decisions about the loans and about Eichenauer’s conflicts.
A compliance professional working for Sagent could have been able to flag these issues for the business and for Eichenauer, had he wanted his stakeholders to know the extent of loan activity.
For all firms wishing to keep investors informed adequately and having questions about disclosure pertaining to conflicts of interest and consent, to get the most from any legal advice sought, all material facts must be disclosed.
Additionally, any and all documents showcasing the disclosure and consent efforts undertaken by the firm following the provision of such advice should be shown to legal counsel and compliance staff before being presumed sufficient.
(Julie DiMauro is a regulatory intelligence expert in the Enterprise Risk Management division of Thomson Reuters Regulatory Intelligence. Follow Julie on Twitter @Julie_DiMauro. Email Julie at email@example.com.)
This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Oct. 24. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters