United States: Portfolio Manager Sanctioned For Government Income Fund Investments

by Bruce G. Leto, Esquire.

The Securities and Exchange Commission ("SEC") recently settled administrative proceedings and sanctioned the portfolio manager of a government fixed-income mutual fund in connection with the fund’s investments and certain disclosures to investors¹.

Piper Jaffray Institutional Government Income Portfolio (the "Fund"), an open-end management investment company, offered and sold shares beginning in June, 1988. The sanctioned portfolio manager had been a portfolio manager of the Fund from its inception through January, 1998, and also served as a senior vice-president of the Fund’s investment adviser, Piper Capital Management. The Fund’s prospectuses, written materials, and shareholder reports stated that the Fund’s investment objective was "a high level of current income consistent with the preservation of capital." However, the portfolio manager invested a large percentage of the Fund’s assets in mortgage-backed derivatives issued by U.S. government-sponsored credit agencies, thereby exposing shareholders to a significant risk of loss of capital.

The Fund was marketed to institutional investors and conservative investors who sought alternatives to certificates of deposit or insured money market accounts. The SEC alleged that the Fund’s marketing materials and communications depicted the Fund as a conservative fixed-income mutual fund that invested in short and intermediate-term U.S. government securities. According to the SEC, the portfolio manager reviewed and approved these marketing materials with the knowledge that they would be distributed to current and prospective investors.

From 1992 to 1994, the portfolio manager invested a large percentage of the Fund’s assets in derivative securities, such as collateralized mortgage obligations, that were high-risk, interest rate-sensitive instruments derived from mortgage-backed securities issued by U.S. government-sponsored agencies. In 1993, approximately 90% of the Fund’s net assets were invested in derivatives, which would react favorably to declining interest rates but lose value if interest rates rose. Investors were not informed that as a result of the Fund’s substantial investment in derivative securities, the value of the Fund would decrease with rising interest rates.

The SEC determined that the Fund did not adequately hold securities that would act as a hedge against rising interest rates. The SEC concluded that the risks of the Fund’s investment in derivatives were further compounded by the portfolio manager’s practice of leveraging Fund assets. The portfolio manager purchased "when-issued" securities, and purchased or sold securities on a "forward commitment" basis. The SEC found that the Fund’s marketing materials contained materially false and misleading statements that the Fund would use these techniques to hedge against rising interest rates. Instead, the portfolio manager used the techniques to purchase securities that would in fact decline in value in a rising interest rate environment, thereby increasing the risks associated with the Fund’s portfolio.

The Fund’s marketing materials and communications compared the Fund to the Merrill Lynch three to five year Treasury index. The SEC concluded that the risks associated with the Fund’s portfolio were greater than the Merrill Lynch index. The SEC determined that the portfolio manager knew and recklessly disregarded such facts. The SEC also found that the portfolio manager falsely stated in numerous Form ADVs, marketing materials, speeches, articles and employment applications that he had received a Bachelor’s Degree in Business Administration with honors from the University of Minnesota.

The SEC concluded that the portfolio manager willfully violated Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities and Exchange Act of 1934 by employing devices, schemes and artifices to defraud investors in the offer and sale of securities. He was also found to have obtained money and property by means of untrue statements of material facts, omitted material facts needed in order to makes certain statements not misleading, and engaged in practices which operated as a fraud and deceit upon purchasers and prospective purchasers of securities. The SEC charged the portfolio manager with willful violation of Section 207 of the Investment Advisers Act of 1940 for making untrue statements of material facts in registration applications and reports filed with the Commission. Finally, the SEC charged the portfolio manager with violating Section 34(b) of the Investment Company Act of 1940 in making untrue statements of material facts and omitting to state material facts in registration statements, applications, reports, accounts, records and other documents required to be kept under Section 31(a) of the Investment Company Act of 1940.

The SEC ordered the portfolio manager to cease and desist from committing or causing any violation or future violation of the securities laws, and to pay a civil monetary penalty in the amount of $100,000. The portfolio manager also was barred for five years from association with any broker, dealer, investment adviser, investment company or municipal securities dealer.

Bruce G. Leto is a partner in and chairs the Securities and Investment Company Department at the Philadelphia-based law firm of Stradley, Ronon, Stevens & Young, LLP..