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Federal Court Bounces Adviser who Claimed SEC Selective Enforcement


The SEC obtained summary judgment against a manager that chose to litigate rather than settle with the SEC over charges that it sold a model that advertised misleading performance that the defendant failed to confirm.  The court rejected the defendant’s selective enforcement defense because the SEC brought several cases against other similarly-situated firms.  The SEC accuses the defendant and its principal with continuing to market the misleading model even after knowing that the advertised performance was misleading and backtested.  The defendant then sold that portion of its business to the model provider without further disclosure.  The defendant’s Chief Compliance Officer identified red flags in the models but recommended offering the models without verifying performance because another third party had purportedly conducted due diligence and other advisers were selling the model.

You can’t beat the SEC.  The SEC hardly ever loses administrative actions and wins 2/3 of federal court cases.  If you do decide to litigate, Constitutional challenges to administrative actions hardly ever succeed.  This case also shows the dangers of hiring an internal Chief Compliance Officer beholden to management.  The CCO here identified the red flags but signed off on marketing the models anyway.  

Co-Investing Fund Manager Engaged in Unlawful Principal Cross-Trading


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 Adopts Fiduciary Standard for Brokers


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. 

The Friday List: 10 Types of Prohibited Revenue Sharing

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).

10 Types of Prohibited Revenue Sharing


  1. 12b-1 Payments from Recommended Funds.  An adviser compounds the violation when lower expense share classes are available.
  2. A percentage of the GP’s carried interest.  Advisers cannot make backdoor compensation from a private fund GP.
  3. A percentage of the management fee.  Platforms have required both registered and private funds to kick back a portion of the management fee to obtain shelf space.
  4. Up-front payment from a fund sponsor.  A one-time, up-front or back-end payment from a product sponsor can also raise questions about required broker-dealer registration.
  5. Directing clients to affiliated brokers.  The SEC will punish this form of revenue sharing where it can prove that clients could have obtained better execution through a non-affiliate.
  6. Revenue-splitting with clearing brokers/custodians.  The SEC will attack firms that receive a portion of the ticket charge, commission, or other fees from clearing brokers or custodians.
  7. Internal allocations among affiliates.  Just because revenue sharing is hidden through internal accounting doesn’t make it less of a conflict of interest.
  8. Fees from recommended vendors.  Advisers must put the client first and should not recommend vendors that pay them or offer discounts.
  9. Sub-transfer agent or administrative fees.  The SEC has cracked down on so-called sub-TA fees ostensibly paid to reimburse advisers for client servicing.
  10. Forgivable loans from clearing brokers.  It’s a conflict of interest when reps have an incentive to steer business to a particular clearing broker to reduce loan principal.

Dual Registrant Will Pay Over $900,000 for Inadequate Mutual Fund Revenue Sharing Disclosure


A dual registrant agreed to pay over $900,000 to settle charges that it breached its fiduciary duty by collecting 12b-1 fees on recommended mutual fund share classes when lower expense share classes were available.  The SEC found inadequate the firm’s disclosure that it received 12b-1 fees because the firm failed to provide “full and fair disclosure that is sufficiently specific so that [the clients] could understand the conflicts of interest… and could have an informed basis on which they could consent or reject the conflicts.”  The respondent failed to self-report to the SEC pursuant to the Share Class Disclosure Initiative, which could have avoided penalties.  The SEC also charges the firm, whose principal serves as Chief Compliance Officer, with failing to implement reasonable compliance policies and procedures.

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. 

General Counsel, Former State Enforcement Lawyer, Pleads Guilty to Securities Fraud


The former general counsel of an alleged ponzi scheme pleaded guilty to criminal charges and was barred from practicing before the SEC because he participated in the scheme by preparing misleading offering memoranda and approving fraudulent advertising.  The U.S. Attorney and the SEC accused the GC, who had previously worked as a state securities enforcement attorney, with making statements in the offering memoranda that the offered notes delivered consistent returns and were fully secured by assets even though the lawyer knew that the issuer did not have nearly enough assets to pay off outstanding notes.  The GC also approved misleading radio and TV advertisements and served as the primary interface with sales and marketing representatives.  News reports indicate that the GC continues to cooperate with the ongoing investigation against his prior partner and firm.

The DoJ and the SEC hold lawyers to a higher standard to understand the applicable securities laws, determine whether statements are misleading, and stop ongoing fraud.  Firms should also beware of lawyers, trying to prove their worth through aggressive practices, entering the private sector through the government revolving door.

Advisers Steered Clients to Private Funds that Shared a Portion of the GP Carried Interest


The SEC has commenced enforcement proceedings against an adviser and its principals accused of recommending private funds for which they received revenue sharing without disclosure.  The SEC asserts that the respondents received upfront and ongoing asset-based compensation from the fund managers in the form of trailers and a percentage of the GP’s carried interest.  The client/investors were shuttled into feeder funds and/or separate share classes that offered lower returns to compensate the respondents.  The SEC charges that the adviser failed to properly disclose these conflicts of interest even after warned by OCIE examiners.  One of the principals served as CCO but failed implement or test procedures and failed to disclose the revenue sharing arrangements to an outside compliance consultant he retained.

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. 

Regulation BI Includes Accredited Investors, According to New FAQs


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. 

Federal Court Rules that Chief Compliance Officer Lacked the Necessary Qualifications

 A federal court found that a Chief Compliance Officer violated the Advisers Act’s compliance rule because he was unfit for the role he undertook.  The court determined that the CCO acted recklessly by assuming the compliance position despite his “complete lack of qualifications for that job.”  The court also found that the CCO aided and abetted his firm’s other regulatory violations including commingling of client assets, inflating valuations, and misappropriating assets.  The CCO was fined and barred from the industryThe firm and the firm’s principal were also fined and barred.

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.