By Joseph Arshawsky, J.D.
All but one of the violations enforced by the SEC against ZPR Investment Management, Inc. and its sole owner, Max E. Zavanelli were affirmed by the U.S. Court of Appeals for the Eleventh Circuit. As a result, the civil money penalty against Zavanelli was reduced by $75,000, and the penalty against ZPRIM was vacated and remanded for recalculation (ZPR Investment Management, Inc. v. SEC, June 30, 2017, Martin, B.).
Zavanelli founds ZPRIM. In 1994, Zavanelli founded ZPR Investment Management (ZPRIM), an investment firm registered as an investment adviser with the SEC. Zavanelli was ZPRIM’s president and sole shareholder. The Global Investment Performance Standards (GIPS) are universal, voluntary standards used by investment managers for quantifying and presenting investment performance that ensure fair representation, full disclosure, and apples-to-apples compliance. Under GIPS, if a firm chooses to advertise that it is GIPS compliant, that firm must also comply with the GIPS advertising guidelines, which specifically require that the firm provide: (1) period-to-date composite performance results and (2) either one-, three-, and five-year cumulative annualized composite returns or five years of annual composite returns.
Violations and sanctions before the SEC. ZPRIM hired a GIPS verification firm to help bring ZPRIM into compliance. In January through April 2008, ZPRIM placed advertisements in financial magazines claiming that it was GIPS compliant. Those initial ads complied with the guidelines. In the fall of 2008, ZPRIM published more ads claiming GIPS compliance; but instead of disclosing the called-for returns with unflattering information, ZPRIM showed its returns over a longer period of time during which ZPRIM outperformed its benchmark indexes. ZPRIM also sent out newsletters in April and December 2009 that claimed GIPS compliance, yet failed to include the required information.
In contrast to the April 2009 newsletter, the December 2009 newsletter contained several corrective statements. Although it is true that the December 2009 newsletter said on one page that "all numbers are GIPS compliant," the next page contained a number of disclaimers, such as "The investment report you are reading is not GIPS compliant. It was never intended to be nor can it be… Our report remains not GIPS compliant."
In January 2010, the SEC sent ZPRIM a letter that ZPRIM may have violated Section 206 of the Advisers Act and Rule 206(4)-1. Despite the letter, ZPRIM told Morningstar, a major provider of independent research, that there were no pending SEC investigations of ZPRIM. Such representations were made first for the period ending on September 10, 2010, and again for the period ending March 31, 2011.
SEC findings. The SEC found ZPRIM violated sections 206(1), (2), and (4) of the Advisers Act by making false or misleading claims (a) in the fall-2008 and spring-2011 magazine ads and in the 2009 newsletters, that it was GIPS compliant; and (b) in the 2011 Morningstar report that it was not under SEC investigation. The SEC also found ZPRIM violated Sections 206(2) and (4), which require only a showing of negligence, for the Morningstar report. The SEC found Zavanelli liable under sections 206(1) and (2) for all the charges involving misrepresentations of GIPS compliance. The SEC found him liable both directly and for aiding and abetting ZPRIM. He was not found liable for the Morningstar reports.
The SEC imposed an industry bar on Zavanelli and ordered both ZPRIM and Zavanelli to cease and desist their misconduct. Finally, the SEC imposed civil penalties of $570,000 against Zavanelli, and $250,000 against ZPRIM. ZPRIM and Zavanelli timely appealed to the Eleventh Circuit, which affirmed everything but the December 2009 newsletter violation. Zavanelli and ZPRIM challenged the SEC’s order on two grounds. First, they said the SEC’s factual findings about both materiality and mental state were not supported by substantial evidence. Second, they argued that the SEC abused its discretion in imposing sanctions.
Materiality. ZPRIM argued that their omission of GIPS-required information was not material. The court of appeals disagreed because substantial evidence showed that reasonable investors would find it important that ZPRIM’s ads did not actually comply with GIPS even while they claimed compliance. Investors looking at the ZPRIM ads could have believed they were looking at the uniform, standardized set of returns required by GIPS when, in fact, ZPRIM deviated from the standardized presentation in order to put its investment performance in a more favorable light.
For the ads published in the fall of 2008, the showing of materiality was even stronger. If ZPRIM had listed its investment returns in those ads as required by GIPS, the information would have revealed that ZPRIM was significantly underperforming its benchmark. Certainly, a prospective investor would have wanted to know about those undisclosed negative results. The materiality inquiry is limited to what investors knew at the time the false statements were made, so ZPRIM’s later disclosures do not negate the materiality of the earlier misrepresentations. The problems caused by a false ad cannot be cured by passing along corrected information to the very customers the company attracted through the misinformation in the first place.
ZPRIM and Zavanelli also challenged the SEC’s finding of materiality for the false claims of GIPS compliance in ZPRIM’s April and December 2009 newsletters. They argued that the two newsletters did not actually claim to be compliant with GIPS. The court of appeals rejected this argument with respect to the April 2009 newsletter; however, the December 2009 newsletter sufficiently disclaimed GIPS compliance. The false claim of GIPS compliance in the April 2009 newsletter was material for the same reasons the false claims of GIPS compliance in the advertisements were material. However, the particularized cautionary statements in the December 2009 newsletter (discussed above) led the court of appeals to conclude that the SEC’s finding of materiality for that newsletter was not supported by substantial evidence. The court, therefore, reversed the SEC’s finding that ZPRIM and Zavanelli violated Sections 206(1), (2), and (4), and Sections 206(1) and (2), respectively, based on the December 2009 newsletter.
Scienter. The evidence showed that Zavanelli knew the claims of GIPS compliance in the fall 2008 ads were false but he approved them anyway. Also, despite ZPRIM’s assurances to the SEC that it would change its ads, the firm published its 2011 ads without the GIPS-required information. Zavanelli conceded that this omission made the claim of GIPS compliance "untrue," and also conceded he conceived of and approved the spring 2011 round of "untrue" ads. This also established that he acted with scienter. Further, Zavanelli, who wrote "most of the newsletter," failed to include the GIPS-required data in the April 2009 newsletter. This was sufficient to support the SEC’s finding that ZPRIM knowingly published the false claim of GIPS compliance in the April 2009 newsletter.
The SEC found ZPRIM liable for falsely stating in two Morningstar reports that it was not under SEC investigation. The SEC found ZPRIM acted with negligence for the 2010 report and scienter for the 2011 report. The court of appeals concluded that both of those findings were supported by substantial evidence. The court found that a person exercising a reasonable degree of care would have updated the 2010 form once the firm received express notice from the SEC of the pending investigation. As to the 2011 report, ZPRIM’s employee made a deliberate decision not to disclose the SEC investigation because the firm "downplayed" its significance and, thus, admitted to an "intent to deceive" investors.
Sanctions. The SEC did not commit a "gross abuse of discretion" in imposing the industry bar on Zavanelli. In assessing the "public interest" prong, the SEC analyzed the Steadman factors and found that each factor showed the bar would be in the public interest. Further, because the SEC found violations of the antifraud provisions of the Advisers Act, the cease and desist orders were entitled to be issued. Because the SEC’s order made clear that it assessed a $75,000 penalty on Zavanelli for the December 2009 newsletter, the court vacated only that portion of his monetary sanction. However, for ZPRIM, the SEC did not impose penalties for each violation, but a single $250,000 penalty combined. Consequently, the court vacated ZPRIM’s penalty and remanded it to the SEC for a determination of the amount, if any, by which that penalty should be reduced.
The case is No. 16-15322.
Attorneys: Philip J. Snyderburn (Snyderburn, Rishoi & Swann, LLP) for ZPR Investment Management Inc. Emily T. P. Rosen for the SEC.
Companies: ZPR Investment Management, Inc.
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