RIA Compliance Blog
The Securities and Exchange Commission recently issued three Orders Instituting Administrative and Cease-and-Desist Proceedings relating to the misuse of quantitative models in managing customers’ accounts. Four entities affiliated with Transamerica and two individuals associated with one of those entities were charged with violating the Investment Advisers Act of 1940 (“Advisers Act”) and Advisers Act Rules. The Orders allege that AEGON USA Investment Management LLC, Transamerica Asset Management, Inc., Transamerica Capital, Inc., and Transamerica Financial Advisors, Inc., marketed various products and investment strategies that used a “proprietary quant model” while failing to verify whether the models functioned as intended and without disclosing known risks connected with the models. The Transamerica entities and the individuals, Bradley Beman and Kevin Giles, submitted offers of settlement to resolve the charges.
According to the SEC’s Orders, the “quant models” were designed to be used, and were ultimately used, to manage, investments within variable annuities and mutual funds. Transamerica entities marketed the products and strategies which used the proprietary “quant model” from July 2011 through June 2015. In 2010, one of the Transamerica entities retained an analyst who, according to the order, lacked experience in portfolio management, and requested that he produce quantitative models to be utilized in implementing investment strategies. The Transamerica entities did not provide the analyst training or oversight as he developed the models. In 2011, the Transamerica entities had identified possible risks relating to the use of the models, but they nevertheless proceeded to launch ten products and strategies based on the models. The SEC also found that the Transamerica entities did not disclose to investors that the analyst tasked with the responsibility of designing the products lacked experience.
The SEC’s Orders also allege that the Transamerica entities began offering the product and strategies “without taking steps to confirm that the models worked as intended.” One of the entities, AEGON USA Investment Management LLC, served as the sub-adviser in implementing the models in clients’ accounts. AEGON allegedly neglected to adopt and implement a written model validation policy until July 2013, two years after the products and strategies were first offered. Ultimately, significant errors in the operation of the quant models were discovered by AEGON, who concluded the models were not fit for their intended purpose.
The disclosures regarding use of the models were also inadequate, according to the SEC’s Order. For example, the products’ prospectuses did not mention use of the models at all until March 2014. By that time, the Transamerica entities discovered crucial errors in the models. Likewise, the strategies’ marketing materials never discussed any risks connected with using models.
Two of the Transamerica entities added so-called “Volatility Overlays,” which worked in tandem with the models to provide greater access to the equities markets and the possibility of larger appreciation during market upswings. However, one of the Respondent entities did not disclose that the models were being used in connection with the overlays, nor the risks associated with the use of the overlays. The SEC also found that another entity continued to describe the volatility overlays as merely “guidelines,” when in fact the overlays worked systematically to add equity exposure and therefore increase the risk to the portfolios.
The four Transamerica entities agreed to disgorge approximately $97 million to individuals who invested in their products and strategies. Beman and Giles, who were both found to have contributed to one of the entities’ compliance deficiencies, agreed to pay $65,000 and $25,000, respectively, in civil penalties.
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