In the first enforcement action of its kind, the Securities and Exchange Commission (the “Commission” or the “SEC”) filed a complaint in the Northern District of New York against Pinnacle Advisors, LLC and associated individuals for violations by the NYSA Fund (the “Fund”) of the Commission’s Liquidity Rule applicable to registered open-end mutual funds.
The Liquidity Rule
Section 22(e)-4 of the Investment Company Act of 1940 (the “ICA”), which is commonly referred to as the Liquidity Rule, requires open-end funds to manage and monitor liquidity risk according to a “Liquidity Risk Management Program” (“LRM Program”) established by the fund. A fund’s Board and the Administrator of the LRM Program are both responsible for managing liquidity risk. The Board is charged with initially approving the Program, approving a designated Administrator, and reviewing, at least annually, a report from the Administrator. Directors are expected to exercise their reasonable business judgment in overseeing the Program on behalf of investors. The LRM Program may categorize investments as “highly liquid,” “moderately liquid,” “less liquid,” or “illiquid,” depending on the time within which the asset could be liquidated, based on reasonable expectations. If the fund’s illiquid assets drop below 15% of its net assets, the Administrator must (pursuant to the Fund’s internal rules) notify the Board of Directors within one day and explain how the fund plans to bring its illiquid assets under the 15% limit within a reasonable period of time. The fund is required to file a confidential notice with the Commission reporting the breach. Board members are expected to follow up after no more than 30 days to evaluate the percentage of illiquid investments.
The Violations
According to the Commission’s Complaint, during the relevant period, the NYSA Fund’s assets included between 21 and 26.38% of illiquid investments consisting of restricted securities subject to significant (albeit fairly standard for a private company) contractual transfer restrictions. The Fund’s written valuation procedures stated that all such restricted securities were deemed to be illiquid. The Board’s Valuation Committee and Audit Committee were responsible for valuing the Company Shares every month according to GAAP.
Pinnacle, a registered investment advisor, managed the Fund’s assets. Pinnacle’s only client was the NYSA Fund. Pinnacle’s President (and 30% owner) served as the President and Portfolio Manager of the NYSA Fund. Other individuals involved in the violations were Pinnacle’s Chief Compliance Officer (a 10% owner of Pinnacle), and two independent trustees who served on the Fund’s Valuation and Audit Committees. These individuals were named as defendants in the enforcement action brought by the Commission.
In mid- 2017, both the Fund’s Auditors and Legal Counsel advised the Board via its Audit Committee that the Fund’s position in the illiquid shares was a problem to be addressed. In 2018, the Fund filed the required report notifying the Commission that 20% of the Fund’s net assets consisted of the illiquid company shares, but claimed that the 15% limitation rule was not violated unless the excess resulted immediately and directly from the acquisition of any security. The Fund had held the shares for over thirteen years. Fund Counsel advised that this was a concern and that the Fund would need to have an LRM Program in place, and develop an exit strategy for the securities, by June 2019.
In May of 2019, the Fund’s President and Portfolio Manager asked the issuer to assist the Fund in selling its shares, but the Company refused. Against the advice of Counsel, the Fund’s portfolio manager and president (and others) advised the SEC that the shares were “less liquid” rather than illiquid investments, based on incorrect facts about the company. Fund Counsel and the Fund’s auditors subsequently resigned. Eventually, the Fund deregistered with the SEC and began liquidation.
The individual defendants and Pinnacle were charged with aiding and abetting the Fund’s violations of the Liquidity Rule, and the individual defendants were charged with violating the ICA’s Rule requiring a fund to report any breach of the 15% rule and inform the Commission of its plan to reduce the illiquid investments within a reasonable period.
Takeaways
This case could signal new interest on the part of the Commission in bringing actions against persons and entities who violate, or assist in violations of, the liquidity requirements imposed on investment funds. NYSA was not a private fund. Nevertheless, all funds should be mindful of a concern by regulators regarding liquidity. Many private funds hold all or portions of their portfolios in illiquid, restricted securities.
In light of the recent bank failures, all government regulators, both state and federal, will doubtlessly be alert for any possible liquidity issues. Liquidity will be focused upon as a component in asset valuation going forward.
Regulators are seeking ways to monitor systemic risk, and will be alert for what they perceive to be red flags. Note that the Commission recently adopted new reporting requirements for advisors to all private equity funds, along with significant amendments to Form PF for advisors to large hedge funds and private equity funds. Even if a private fund is not subject to the Liquidity Rule or required to file a Form PF, private funds, and their related entities and individuals, should be excessively mindful regarding representations made to investors in private placement memoranda and ongoing periodic reports regarding valuation of the fund’s assets, investment strategies, and any events signaling a possible need to liquidate assets. It would be wise to fully document both the exercise of reasonable business judgment and the implementation of effective internal controls with respect to these issues.
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