SEC Complaint Against a VC Exempt Reporting Adviser

On August 13, 2019, the SEC filed a complaint against Stuart Frost and Frost Management Company, LLC for violating the antifraud provisions of Sections 206(1)-(2) and 206(4) of the Investment Advisers Act.  This case is a reminder that certain provisions of the Advisers Act apply to all investment fund managers, regardless of whether they are registered, non-registered, or exempt (exempt reporting advisers are referred to as "ERAs").  Also, this case highlights once more the importance of proper disclosure of management fees and expenses (and that they have to be reasonable and market).

Mr. Frost, through his investment management firm, managed five venture capital funds that raised about $63 million.  These funds were invested into start-ups incubated by Frost Data Capital, LLC ("FDC"), an entity wholly-owned by Mr. Frost.  Start-ups paid incubator fees to FDC.  The SEC complaint alleges that these incubator fees were not properly disclosed to the investors and, in fact, were exorbitant.  As stated in the SEC press release, the fees were used to finance Mr. Frost's "extravagant personal expenses" and "lavish lifestyle", and when he ran out of money, he would create and fund new start-ups in order to obtain more incubator fees.

Section 206 of the Advisers Act Applies to All Fund Managers

The anti-fraud provisions of the Advisers Act apply to ALL investment advisers, regardless of their status with the SEC or state authorities, or the absence thereof. In particular, Section 206 of the Advisers Act states:

"It shall be unlawful for any investment adviser by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly—

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client; ...

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative."

Further, all investment advisers owe a fiduciary duty to their clients of undivided loyalty and may not engage in any activity that conflicts with the interests of their clients without their prior consent.  As held by the Supreme Court in SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the advisers owe to their clients a duty of good faith and full and fair disclosure of all material facts and a duty to avoid misleading them.

According to the complaint, FDC (wholly-owned by Mr. Frost) was financially dependent on the incubator fees paid by portfolio companies.  FDC charged the portfolio companies $21.69 million in incubator fees.  None of that money went to the investors.  In the fund disclosure materials, Frost and his management company either completely omitted the existence of such incubator fees or misled the investors by saying that FDC would charge incubator fees on a case-by-case basis and at below-market rates.  In reality, every portfolio company was charged with such fees, which were $30,000 - $40,000 per month per portfolio company.  The fees had to be paid even if the portfolio company moved out of FDC's offices.  The service contracts could be canceled only upon a 180-day notice, which meant that the startups had to pay for an additional six month period.  Unsurprisingly, these ongoing payments reduced the chance of the startups to succeed, as they were quickly running out of cash.  Overall, there were 24 portfolio companies.  As of 2018, only several remained active.

ERAs Must File with the SEC 

According to Section 202(a)(11) of the Advisers Act, an "investment adviser" is any person that (1) for compensation (2) is engaged in the business of (3) providing advice (4) as to the value of securities or advisability of investing in, purchasing, or selling securities.  The Advisers Act mandates that all investment advisers must register with the SEC, unless exempt or prohibited to do so.  

A fund adviser may be exempt from registering with the SEC if it is an adviser solely to private funds with total AUM under $150 million and that are (i) venture capital funds (Section 203(l) of the Advisers Act) or private funds relying on Section 3(c)(1) or 3(c)(7) exemption under the Investment Company Act (Section 203(m) of the Advisers Act).  Such fund managers must still file Form ADV with the SEC, but a shorter version.

There is also a duty to file annual updates of the Form ADV.  Frost Management Company failed to renew its ERA filing in 2018 and onwards.

In conclusion, this case reminds us that the SEC has jurisdiction over all investment advisers, including the ERAs and the unregistered advisers.  Being an investment adviser, registered or not, big or small, carries the fiduciary duty of good faith and full and fair disclosure that should not be taken lightly.  

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.