When it comes to the all-important topic of management and other fees or expenses, investment advisors are charged with the fiduciary responsibility of making certain they disclose all related information comprehensively and transparently.
The alleged failure of Stuart Frost and Frost Management Company, LLC, of Laguna Niguel, Calif., to disclose $14 million of hidden and excessive incubator fees prompted the Securities and Exchange Commission (SEC) to file charges of fraud on August 14, 2019.
The SEC’s charges offer a textbook example of how investment advisory firms can run afoul of regulators when their compliance departments don’t “follow the money,” a popular catchphrase from the Watergate scandal of the 1970s.
In its complaint, the SEC said Frost and his investment advisory firm raised nearly $63 million for five venture capital funds between 2012 and 2016 and invested it in a portfolio of start-up companies. The nascent companies then paid incubator fees to a Frost-owned company called Frost Data Capital, ostensibly for operational support and other services.
Frost allegedly used a significant portion of the excessive and undisclosed fees to fund a lavish lifestyle that included a personal chef and housekeeper, an archery range, beach club membership, a boat, and luxury cars. According to the SEC complaint, Frost took in $3.4 million from 2012 through 2016 and expensed over $867,000.
The SEC alleged that when Frost got short on cash, he created new portfolio companies, invested more money from the venture capital companies, and had Frost Data Capital extract more incubator fees. He also failed to disclose the existence or the actual amount of the fees and charged the venture capital funds hidden and improper management fees.
The biggest takeaway for investment advisors from the Frost case is that detailed transparent disclosures are mandatory, especially when it has to do with compensation arrangements with service providers, affiliated companies that provide services to clients, or any of the underlying companies you invest in. It is critical to disclose all conflicts of interest to all clients through comprehensive disclosures in offering and other regulatory documents.
Regardless of whether Frost and his firm profited from the fees, they did not disclose it properly. They had misleadingly represented that the incubator fees that would be charged on a case-by-case basis, which is insufficient, and that the charges would be at or below market rate for the services.
One of the main points the SEC keeps telling advisers and companies through enforcement action is that a firm must have very detailed and transparent disclosure. When chief compliance officers do their reviews, they must be sure that they always ‘follow the money.’ If the firm won’t give them copies of the financials, there could be an issue.
Every investment advisor registered with the SEC is required to have a CCO. The firm itself has a fiduciary duty as an advisor, and it’s the CCO’s job to make certain the proper documentation is on file. The CCO should make certain the firm could substantiate fee disclosure made in the Form-ADV or in the offering document.
There have been times that CCOs have been named in SEC complaints. When a small firm has a CCO that’s also the head of the firm or has other hats in the firm, there’s not enough time for them to do compliance and attend to their other job responsibilities. Having personnel devoted to compliance or external compliance resources to assist are best practices for investment advisory firms.
If an advisory firm recommended Frost funds to their clients and did not perform detailed due diligence on the funds, the SEC could go bring potential action against the advisor because there was information that was not properly disclosed or was misleading. The fact that you’re recommending a fund to an accredited investor doesn’t get you off the hook if you’re not performing ample due diligence.
Core Compliance can help your firm establish best practices in fee disclosure. For more information, please contact us today.