The SEC fined and censured a private fund manager and its principal for engaging in unlawful interfund cross trades. The firm’s founder/CEO owned more than 35% of one of the funds, so that multiple trades between the fund and other funds and SMAs advised by the fund manager triggered principal trading rules that require disclosure and client consent. The trades occurred during a period when the fund manager was an exempt reporting adviser and later when it registered with the SEC. The respondents are also charged with failing to adopt and implement reasonable compliance policies and procedures.
For those otherwise uninformed about the regulatory requirements, a principal trade between an adviser and its client (including a client fund) requires consent of all clients involved. The SEC makes clear in this case that the 35% ownership threshold triggers the principal trading rules. Also, the SEC will attack principal trading even by exempt reporting advisers.
Massachusetts has adopted a fiduciary rule for broker-dealers and their agents. The rule applies broadly to any investment advice or recommendation to any customer other than an institutional buyer. A broker has a continuing fiduciary obligation when the broker has investment discretion or has assumed a contractual obligation to monitor a client’s account. A broker must make reasonable inquiry into a client’s investment objectives, risk tolerance, and financial situation and disclose, avoid, eliminate and mitigate all conflicts of interest. The rule becomes effective on March 6, and enforcement commences on September 1.
Until courts resolve the potential conflict between the Massachusetts fiduciary standard and Regulation Best Interest, we recommend that brokers observe the (arguably) higher Massachusetts standard if they have customers there.
Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues. Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.
Recently, we declared that revenue sharing was dead. Although, in theory, sufficient disclosure should allow advisers to receive revenue sharing, in practice, the SEC attacks revenue sharing in all its forms regardless of the extent of the disclosure. Our conclusion is that the SEC has effectively banned revenue sharing. As support for our position, below are ten types of revenue sharing outlawed by the SEC (cases hyperlinked).
Revenue sharing is dead. We don’t think an adviser could include enough disclosure to satisfy the SEC where the adviser recommends a share class more expensive that a comparable share class that does not result in adviser payola. Also, this case is another example of the failed dual-hat Chief Compliance Officer model.
This case reads like a compliance what-not-to-do handbook. Conflict of interest? Check. Undisclosed payola? Check. Reducing client returns? Check. Failing to implement procedures or testing? Check. Dual-hat, conflicted CCO? Check. Ignoring OCIE deficiencies? Check. The adviser has already withdrawn to state registration. We expect a bleak litigation future for these alleged wrongdoers.
New FAQs for Regulation Best Interest and Form CRS provide guidance on how to handle accredited investors, what is a “recommendation”, how to define “retail investor”, and how to address affiliate services. RIAs and BDs must apply Regulation BI and send Form CRS to accredited investors because the definition of retail investor does not exclude high-net worth natural persons and accredited investors, according to the SEC’s Trading and Markets staff. A retail client does not include a legal representative (e.g. RIA, BD) of a retail client but would include non-professional legal representatives (e.g. trustees, executors, attorneys-in-fact). The FAQs also address several affiliate relationships, generally allowing the use of a single Form CRS so long as you can fit all the required disclosure in 4 pages. Certain investor education – general information about retirement planning, minimum distributions – would not be considered a recommendation. An RIA that provides services solely to another RIA would not have to deliver a Form CRS to its client’s retail clients.
Because the Form CRS is new and the “best interest” standard has no common law history (like the fiduciary standard), the SEC has its work cut out to define what’s required. Compli-pros must keep watch for future FAQs as the staff has already published three sets of FAQs since November.
The Chief Compliance Officer must be “competent and knowledgeable” in the Advisers Act, according to the compliance rule’s adopting release. An unqualified CCO in and of itself violates the compliance rule and can result in significant firm and personal liability. Every firm should retain a third party CCO firm or hire a qualified regulatory professional. Appointing whoever drew the short straw at the management meeting won’t cut it with the SEC.