It is standard practice for counsel drafting offering documents for investment funds, whether registered with the SEC or not, to describe the fund’s investment strategy. Failure to describe the strategy would make the fund a type of “dark pool” (investing in a fund vehicle about which the investors are told nothing about what they are investing in). Black pools are frowned upon, to say the least. The description is almost always detailed, describing the positions, the markets, and the risks entailed in pursuing the described strategy. The SEC, and private parties, have brought litigation against fund managers for harm violating the investment strategy described in fund documents. These claims are for “style drift” – abandoning in whole or in substantial part the stated strategy in favor of a new, undisclosed, and, as facts from litigation show, more risky strategy.
Why should managers of funds not registered with the SEC care about style drift? We know what SEC staff are collecting information about investment styles from Form ADV, Form PF and other filings mandated by the SEC. Failure to adhere to an investment strategy described in regulatory filings would itself be the basis for regulatory action. Moreover, in cases where the SEC is investigating a manager for issues other than style drift (e.g., overcharging fees) style drift can function as another “arrow in the quiver” in an enforcement action. Moreover, in cases where a manager is sued by investors over investment losses, charges of style drift are the type of claims that can be understood by judge and jury if it comes to that.
The SEC’s civil action against UBS Willow Management LLC and UBS Fund Advisor LLC (2015-2017) (together, “Willow”) demonstrates how things can go very wrong even in a large manager that is an affiliate of a multinational financial giant. This registered fund pursued a strategy involving distressed debt securities from 2000 to 2008. In late 2008, without advising its investors and, in fact misrepresenting to investors that it continued to pursue the distressed debt strategy, the fund switched to a short credit strategy through credit default swaps. The new strategy greatly increased risks to investors and in fact resulted in an eight-figure loss to investors. The bottom line: “UBS Willow Management was aware of the change in the Fund’s investment strategy and knew or should have known that the representations in the OM [Offering Memorandum], marketing brochure, and investor letters were false or materially misleading. UBS Willow Management also knew or should have known that it omitted certain material information about the change in investment strategy in discussions with the Board.” (SEC Order)
What went wrong at Willow? After all, how could such a large, sophisticated financial institution as UBS sponsor such a flagrant flouting of the regulations governing registered investment companies? The SEC’s recital of the facts indicates that Willow was a joint venture formed in 2000 with Bond Street, a small independent advisory firm. It can be inferred from the facts stated by the SEC that Willow was not adequately supervised by UBS and arguably acted in effect as a kind of “rogue” affiliate. The result: a real black eye for UBS.
The SEC took style drift very seriously in the Willow case: there, style drift was obvious as a completely new investment strategy was adopted, fund communications to investors were deliberately misleading and substantial market losses accrued. Willow’s attempt to obfuscate its shift to a completely new strategy (from long credit to short credit) appears, in hindsight, to have been ill advised.
For managers of investment companies not registered with the SEC, there have been notable style drift cases, most notably, Harbinger Fund, where a completely new strategy (e.g., short squeeze) was adopted without disclosure to investors. In Harbinger, style drift was accompanied by charges of serious wrongdoing by the fund and its manager and affiliates, including misappropriation of fund assets. SEC charges and private litigation ensued.
What consequence to private fund managers? First, unlike registered funds, which are required to describe the strategy, a private fund’s counsel often advises the manager to include a “catch-all” description. In addition to the described strategy or strategies (as in a multi-strategy fund) the investor is advised that the fund may pursue any other (“catch-all”) (undescribed) strategy in the manager’s discretion.
If a fund shifts to a new, undescribed strategy, is the catchall reference in the offering document sufficient to rebut claims of style drift, which are unlikely to arise only if the new strategy generated losses. The manager could have provided notice to investors of the new strategy, but, failing to do so, what is the manager’s defense? Providing contemporaneous notice to investors of a change in investment strategy appears to us to be the prudent course, particularly in light of problems faced in the cases described here. The financial markets are hardly static and changing course in light of changed conditions, if explained to the investors, would provide a reasonable position for the manager. The likelihood that a particular strategy will be a winner forever is dicey, and adapting to changing circumstances is not unreasonable in our view, provided disclosure is made.