Fund Advisers Reject SEC Aiding and Abetting Charges

The advisory firm cited in a mutual fund Liquidity Rule violation case brought by the Securities and Exchange Commission rejected the claim that the firm aided and abetted the fund in breaking the SEC’s liquidity requirements. The case represents the first enforcement action taken by the SEC under the Liquidity Rule, enacted in 2016.

In a September 25 filing, defendants argued that the SEC must prove that the firm contributed to the misclassification of the assets as opposed to merely not preventing it.

The SEC initially alleged in May that Pinnacle Advisors LLC and the independent trustees for a mutual fund, the NYSA Series Trust, intentionally misclassified assets in the fund as “less liquid” when they should have been classified as “highly illiquid.”

This is an important distinction, because SEC liquidity requirements cap the amount of “highly illiquid” assets, defined as those that cannot reasonably be sold within seven days, at 15% of a fund’s total value. This is to ensure that mutual funds can meet investor redemptions within seven days, as required by federal law. Mispresenting the liquidity status of an asset can make a fund that is not compliant with this rule appear compliant.

The SEC alleged that the fund, now a liquidating trust, held more than 15% of its assets in equity of a private medical device firm, the shares of which had sale restrictions which could take as long as 28 days to satisfy before the shares could be sold to other investors.

In July, the defendants answered that Pinnacle did not aid and abet the fund. They argued that the fund informed investors that the assets in question were indeed illiquid in disclosures and that the fund sent a “preliminary” letter to an SEC staff member informing the SEC the assets were “less liquid.” The preliminary note was not reviewed nor approved by the trustees, according to the filing, and the trustees therefore did not aid or abet the alleged violation, because inaction cannot be aiding and abetting.

Additionally, the trustees, most of whom are affiliated with Pinnacle, argued that the current Liquidity Rule is vague in its application and relies on the subjective judgment of fund experts, to which the SEC should be more deferential. Pinnacle’s filing further argued that the SEC tacitly acknowledged this problem by proposing a new liquidity rule, sometimes called the Swing Pricing Rule, which the defendants say is more objective in character: “The SEC has proposed material amendments to all three provisions of the Liquidity Rule at issue in this case in tacit admission that the rule lacks clarity.”

The swing pricing proposal is pending SEC review and finalization and is not in effect.

The SEC, in a response filed in August, argued that inaction can be aiding and abetting if the party in question has a “duty to act.” The SEC argued that Pinnacle and the trustees ignored advice from the fund’s counsel, who allegedly resigned over the issue, and that the fund misclassified the assets to avoid having to sell them in order to return to compliance. The SEC noted that it has been four years since the classification took place, and the liquidating trust still has not been able to find a market for the private shares in question.

As for the clarity of the rule, the SEC argued that the new proposal is just a proposal and cannot be used against an existing rule as evidence that the current rule in unworkable.

On Monday, attorneys for two of the trustees answered that the SEC needs to argue that the trustees offered “substantial assistance” to support an aiding and abetting case and that case law does not support the SEC’s “duty to act” assertion. The trustees further argued that the Liquidity Rule does not require trustees to classify assets by their liquidity status; instead, that is the duty of the fund itself.

The case, filed in U.S. District Court for the Northern District of New York, is SEC vs. Pinnacle Advisors, LLC; Robert F. Cuculich, Benjamin R. Quilty, Mark E. Wadach and Lawton A. Williamson, case number 5:23-cv-00547.