Did AI just result in 13 settlements?

At the beginning of June, the SEC announced settlements against 13 private fund advisers[1] for failing to provide the required information in Form PF.[2] Generally, Form PF requires information on private funds managed by investment advisers if the total assets of the private funds are over $150 million. The form, which became effective in 2012, asks for information on a private fund’s assets under management, strategy, performance, investments, and other areas. The form must be updated annually or when there is a material change to the information in the most recent filing. As stated in its orders, the SEC and other regulatory, such as the Financial Stability Oversight Council, use the information in Form PF to watch systemic risk in the private fund industry. Additionally, the SEC uses the form in regulatory exams and investigations. (Emphasis added.) The same is true for Form ADV.

For the most part, the sanctioned investment advisers failed to file their Form PF over many years. For example, Bachrach Asset Management, Inc. failed to file its Form PF from 2012 through 2016. The SEC was, presumably, able to find Bachrach because the firm did file its Form ADV, which listed the firm’s regulatory assets under management at $206.9 million, all of which were in pooled investment vehicles other than investment companies and business development companies (i.e., in private funds). Interestingly, Form ADV also requires investment advisers to name their chief compliance officer or another person that can answer questions about the firm’s regulatory filings. In both instances, Bachrach failed to name anyone, a telling sign. This fact pattern was common throughout the 13 orders. All the sanctioned investment advisers had private fund assets under managing over $150 million, and many had assets under management that exceed $1 billion. Given the size of their operations, they likely had enough resources to hire a compliance consultant or law firm to manage these filings. In fact, the $75,000 penalty was equal to at least ten years of hiring an outside expert to prepare and submit the Form PF filing.

More importantly, these 13 separate matters show how the SEC is using the data that it collects to find firms that are failing to comply with federal securities laws. It’s easy to imagine how the SEC could compare data in Form ADV to data in Form PF and identify inconsistencies. The industry needs to wake up to the fact that the SEC is getting better at using data to identify compliance gaps. Take, for example, the SEC’s Share Class Selection Disclosure Initiative (the “Initiative”), which was launched by the Division of Enforcement on February 12, 2018. The SEC says that through its examination program it has repeatedly noticed that investment advisers are failing to provide sufficient disclosure around the selection of mutual fund share classes and the role that 12b-1 fees play in that process. According to the SEC, the deficiencies are related to the investment adviser’s disclosure in its Form ADV Part 2, which fails to state affirmatively that the investment adviser will place the investor in a share class that pays a 12b-1 fee to the investment adviser or its affiliate when there is a lower-cost share class available. (Emphasis added.)[3] The SEC could easily create an algorithm that searches Part 2 of Form ADV for keywords such as “12b-1” and “may” in the same sentence. The algorithm would create a list of investment advisers that might have deficient disclosure, which the SEC could then exam more closely. Better yet, the SEC could start by updating its algorithm to look for the keywords plus an affiliated broker, all of which would be disclosed in Form ADV. A quick review of the output list, a few targeted exams, and boom, another press release announcing 13 settlements against investment advisers and their affiliated brokers.

The point here isn’t that the SEC shouldn’t use data analysis to drive its examination and enforcement programs; on the contrary, it’s only fair that the regulator uses the same techniques that the registrants use to drive their sales and product development. The point is that the SEC is becoming more advanced in its use of data analysis, and registrants can no longer skirt under the radar. In today’s data-driven economy, algorithms, neural networks, and other digital tools are going to make everyone more efficient, even the regulators. In a recent article by the Investment Company Institute, the lobbying group recognizes that registrants are using artificial intelligence to “’read [a] vast amount of text data—news, filings, transcripts, call notes—[that] allow an analyst to ‘smart search’…and churn through millions of pages in a matter of minutes.’”[4] And if registrants have access to these tools, it's only a matter of time before the SEC has access to them too.

The SEC's ability to find deficiencies in compliance programs and gaps in disclosure is going to get better. The agency will be able to review more registrants in a shorter period and target its examination and enforcement resources. Even more reason for registrants to make sure they have a sophisticated compliance program and a qualified person to run it. Unfortunately, this also means the cost of compliance is going to increase because the bar is being raised by the SEC. Better compliance should be better for investors, but not if it outweighs the benefits of having a competitive (and still compliant) industry. If the result of better compliance is more concentration in the industry, both in the number of registrants and their investments, then the overzealous focus on compliance may result in higher systemic risk. But of course, that will all be disclosed in Forms ADV, PF, et cetera, and the SEC and Financial Stability Oversight Council will know exactly how to manage it.


[1] These advisers included: Bachrach Asset Management Inc., Biglari Capital LLC, Brahma Management Ltd., Bristol Group Inc., CAI Managers & Co. L.P., Cherokee Investment Partners LLC, Ecosystem Investment Partners LLC, Elm Partners Management LLC, HEP Management Corp., Prescott General Partners LLC, RLJ Equity Partners LLC, Rose Park Advisors LLC, and Veteri Place Corp. You can find a link to each settlement order in the SEC’ press release.

[2] Interestingly, many of the cited advisers were in Maryland, just minutes from the SEC’s headquarters.

[3] Superficially, the SEC seems to say that it would be permissible for an investment adviser to make an affirmative declaration that it will place an investor in a 12b-1 share class so that the investment adviser can increase its compensation. But the SEC’s real intent is to force investment advisers to purchase the lowest cost share class available to an investor. Since this latter stance would conflict with both Rule 12b-1 and the disclosure-based structure of federal securities laws, the SEC is turning the matter into a disclosure issue. Passing new rule or amending Rule 12b-1 has proved to be too difficult for the SEC.

[4] Miriam Bridges, Artificial Intelligence Offers Opportunity for Funds and Investors (Jun. 7, 2018) available at https://www.ici.org/viewpoints/view_18_gmm_broun.

Enforcement Form PF Investment Advisers SEC Advisers Act Artificial Intelligence Compliance Disclosure Form ADV

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