On June 1, 2016, the Securities and Exchange Commission (SEC) announced litigation filed in the United States District Court for the District of Connecticut against Momentum Investment Partners LLC (dba Avatar Investment Management) and one of its principals, Ronald J. Fernandes. The SEC alleges that Avatar and Fernandes engaged in fraudulent or deceptive conduct in violation of Section 206 of the Investment Advisers Act of 1940 by failing to disclose certain fees to advisory clients.
According to the complaint:
- Prior to 2013, Avatar managed several individual client accounts using a proprietary investment strategy focused on exchange traded funds or ETFs.
- In March 2013, Avatar and Fernandes organized four mutual funds and transferred approximately $11 million of client assets into those funds without notifying the clients. These mutual funds charged annual management fees to investors.
- As adviser to the mutual funds, Avatar received the majority of these fees, which did not offset or reduce the management fees they were already receiving from their clients.
- The SEC alleges that Avatar failed to inform clients that their fees would increase even though the mutual funds would use the same strategy previously employed by Avatar with respect to their individual accounts.
- Avatar’s failure to disclose to investors the material conflict of interest inherent in creating a second layer of fees—with no change to its services—underpins the SEC’s charge of fraudulent or deceptive conduct.
The complaint also alleges that Avatar made misleading filings with the SEC in violation of Section 207 of the Investment Advisers Act. Specifically, Avatar’s Form ADV, filed on March 11, 2013, discusses the separate fees charged by the Avatar mutual funds but does not directly state that Avatar received those fees even though no additional services were provided.
Based on the facts presented in the complaint, Avatar and Fernandes made at least three major missteps:
- Avatar never developed a conflict of interest procedure that would have applied in this situation.
- Avatar and Fernandes failed to disclose a material conflict of interest (the double layer of fees) to their investors.
- Avatar clients paid higher aggregate fees when they were moved from separate accounts to the mutual funds, even though Avatar’s investment management services and the investment strategy employed for the accounts and the mutual funds were substantially the same.
What are the implications of the Avatar enforcement action for side-by-side management arrangements in general?
- RIAs should always have thoughtful reasons for moving clients from lower-fee accounts to funds (public or private) in which the RIA earns additional or higher fees.
- If the account and the fund have the same fundamental strategy but the fund employs more active trading or use of leverage (requiring more risk controls/monitoring), the increased trading activity/monitoring may justify that the fund pay a higher management fee to the RIA than the account.
- Moving a client from an account that has no performance fee to a fund that does might be appropriate for the client if the fund charges a lower fixed management fee than the account and the client makes an informed decision with an understanding of how fees will work in different market return scenarios. Note that moving a client to a fund from which the RIA receives a performance fee may be a principal transaction under Section 206(3) of the Advisers Act, requiring written client consent.
- Pooling capital of multiple accounts into a single fund may in certain circumstances reduce overall costs on a per investor basis compared to separate account management, even if the RIA collects a higher management fee in the fund.
- RIAs should clearly disclose fee alternatives for related strategies in Items 5 and 6 of Form ADV Part 2. Disclosure in a client’s investment management agreement or a fund’s disclosure document may also be appropriate. In cases in which the RIA invests a client’s account into a fund managed by the RIA, for the sake of clarity and transparency, the RIA’s fees should, where possible, be charged only at a single level (account or fund) rather than split between multiple levels.
The SEC’s complaint also notes that Avatar used client assets as seed capital for the mutual funds. Although this is not the focus of the complaint, it is another example of Avatar potentially acting in its own self-interest. We can only speculate whether the SEC would have viewed the case differently if the mutual funds were already active at the time Avatar placed its clients in them. Conversely, would Avatar have been subject to charges if it had used its investors’ funds as seed capital for the mutual fund but charged identical fees?
Myrna H. Rooks