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Month: June 2014

Federal Court Upholds Attorney-Client Privilege for Internal Investigations

The United States Court of Appeals for the D.C. Circuit has held that materials from an internal investigation directed by in-house counsel with a primary purpose of seeking legal advice are subject to the attorney-client privilege. The ruling overturned the District Court, which rejected privilege because the investigation was designed to comply with regulatory requirements rather than to seek legal advice. The Circuit Court explained: (i) the internal investigation was not less privileged just because it was required by regulation; (ii) obtaining legal advice must only be a primary purpose of the investigation, not necessarily the only purpose; (iii) outside counsel need not be involved so long as inside counsel directed the investigation; and (iv) interviews can be conducted by non-lawyers so long as they are acting as agents of the legal department.

OUR TAKE: Investment firms can assert privilege for materials arising from internal investigations required by the firm’s compliance manuals mandated by the securities laws. However, if a firm does want to assert privilege, the investigation should be managed by either inside or outside counsel. Regardless, it is less clear how the SEC could attack claims of privilege in administrative proceedings.


SEC Sues Private Equity Fund-of-Funds Manager for Marketing Target Returns

The SEC commenced securities fraud proceedings against a private equity fund-of-fund manager for marketing target returns without a sufficient basis. The SEC says that the firm’s marketing materials claimed that the investment would yield a “7-10x Return on Capital Raise Investment.” The SEC asserts that the respondent had no basis to support these claims because: (i) neither the fund nor its personnel had any history delivering significant returns, (ii) most of the principals’ investment experience resulted in failure, and (iii) the firm was already in a precarious financial position. The SEC also alleges various other marketing misrepresentations, breach of fiduciary duty, and misappropriating client assets.

OUR TAKE: Don’t use target returns in marketing materials. The SEC heavily scrutinizes return assumptions as insufficiently supportable.


NYS Attorney General Sues Large Bank for Dark Pool Fraud

The New York State Attorney General filed a fraud lawsuit against a large international bank, alleging misrepresentations in the operation of its dark pool. The NYS Attorney General alleges that the bank’s marketing materials included false statements about special safeguards it had put into place to protect against predatory high frequency traders. The Attorney General claims that the bank never prohibited any high frequency trading firms but, rather, solicited them by offering “systematic advantages.” The suit also asserts that the bank, contrary to its marketing statements, favored its own dark pool when routing orders.

OUR TAKE: This is the first in what we expect will be a series of state and federal regulatory actions against dark pool operators where the regulators allege lack of operational transparency. Compliance officers are now tasked with learning trading algorithms and IT to ferret out potential misstatements about how their firms operate dark pools.


Private Equity Firm Violated Pay-to-Play and Registration Rules

A private equity firm was censured, fined, and order to disgorge fees for violating the pay-to-play rule and erroneously claiming a registration exemption.  The SEC alleges that an employee of the respondent made campaign contributions to candidates for mayor and governor, each of which appointed members to the bodies that invested public pension funds.  The pay-to-play rule prohibits a firm from receiving compensation during the 2-year period following the contributions.  The SEC also charges the firm for claiming an adviser registration exemption where its assets should have been aggregated with an affiliate that was under common control and shared management and operations.
OUR TAKE: Private equity firms need to take seriously their Advisers Act’s compliance responsibilities.   More significant than the disgorgement, this firm will now have to explain to its institutional clients and prospects why it has a public enforcement order against it.  Also, the SEC will heavily scrutinize an unregistered fund sponsor that “takes a position” that it does not need to register.

Top 5 Regulatory Alerts – May 2014

Here are our Top 5 Regulatory Alerts for May 2014, ranked by
significance.  We have also included the Top 5 most read Alerts (other
than Best of the Web and Top 5).


Top 5 Regulatory Alerts – May 2014

  1. White
    Says SEC is Innovating to Bring Actions against Individuals
  2. OCIE
    Chief Criticizes Private Equity Compliance Practices
  3. SEC
    Addresses Cybersecurity at ICI GMM
  4. FINRA
    Seeks to Revolutionize Regulation with CARDS
  5. SEC
    Sues Adviser Principal for Failing to Conduct Due Diligence


Most Read – May 2014

  1. SEC
    Bars Adviser Who Failed to Disclose Astrology-Based Investment Strategy

  2. BD
    to Pay $850,000 for Hanging Licenses
  3. SEC
    Prosecutes RIA President/CCO for Custody Rule Violations
  4. Private
    Fund Manager Faces Criminal and Civil Charges
  5. White
    Says SEC is Innovating to Bring Actions against Individuals

SEC Commissioner Supports Outsourcing Compliance Exams

SEC Commissioner Daniel Gallagher recently recommended using third party exams to increase investment adviser oversight.  Mr. Gallagher referenced a paper prepared by James Angel, a professor at Georgetown, which outlines the benefits of a third party exam approach.  Dr. Angel proposes that third party reviews could follow the same structure as financial statement auditing.  Firms would be required to retain qualified firms subject to compliance review standards set by the SEC (much like PCAO.  Compliance reviews would be submitted to the SEC on a regular basis.  Dr. Angel notes that the SEC has already set the precedent for such third party reviews by requiring surprise exams of assets under custody.  He also notes that firms already have to do an annual compliance review; this new approach would simply require using an independent third party.  Mr. Angel asserts that outsourcing exams is a much more politically viable option to oversee advisers because it does not involve creating a new SRO and it does not require the SEC to get more funding.
OUR TAKE: We believe that a firm that is serious about its compliance efforts should already retain an independent third party firm to assess its program.  An independent compliance review gives comfort to senior management, clients, and regulators.  One big challenge with the Angel approach is that there are far fewer qualified compliance firms than auditing firms.  

BD to Pay Over $97 Million for Mutual Fund Share Class Violations

A large broker-dealer agreed to refund $89 Million to investors and pay an additional $8 Million fine for failing to waive sales charges and failing to offer the lowest mutual fund share class available.  According to FINRA, the firm’s failures affected 41,000 small business retirement plan accounts and 6,800 charities.  FINRA alleges that the firm knew about the overcharging as early as 2006 but failed to adopt and implement policies and procedures to ensure the financial advisers waived the sales charges or offered lower cost share classes.  Brad Bennett, FINRA’s Executive Vice President and Chief of Enforcement, said that “investors must be able to trust that their brokerage firm will offer the lowest-cost share classes available to them.”
OUR TAKE: The SEC and FINRA have recently stepped up their warnings that brokers and wrap sponsors must offer the least expensive mutual fund share class for each investor.  Compliance should ensure that the firm has adopted and implemented effective policies and procedures that will withstand regulatory scrutiny.

SEC Brings First Case for Retaliating Against Dodd-Frank Whistleblower

A hedge fund manager was fined and ordered to pay restitution aggregating over $2 Million and hire an independent consultant for taking retaliatory job actions against a whistleblower related to trading conflicts of interest.  The SEC charges that the respondent forced the firm’s head trader to resign after discovering that he reported securities laws violations to the SEC.  The head trader/whistleblower notified the SEC that the firm engaged in principal transactions with a proprietary account at a broker-dealer controlled by the respondent’s principal.  The SEC asserts that the firm did not obtain sufficient consent from the hedge fund by submitting it for approval by the general partner’s conflicts committee staffed by personnel reporting to firm management.  Apparently on the advice of the firm’s employment counsel, the firm removed the whistleblower from his position as head trader, took away his email account, barred him from the premises, and then demoted him into a make-work assistant compliance position from which he ultimately resigned.  The Dodd-Frank Act prohibits retaliation against employees acting as whistleblowers.
OUR TAKE: Dodd-Frank’s whistleblower provisions should make firms consider implementing an element of independence into their compliance programs.  Whether a firm hires an independent third party compliance provider or ensures that the CCO reports to an independent board, registrants need to give potential whistleblowers an outlet to uncover regulatory issues without being forced to go straight to the regulator.  Separately, private fund sponsors should note that GP approval of principal transactions will not cure the conflict of interest.


CCO Punished for Code of Ethics Violations

The SEC censured, fined, and barred a Chief Compliance Officer for failing to implement and test the Code of Ethics, thereby failing to stop or detect the insider trading by a portfolio manager.   The SEC says that the CCO failed to: (a) include the subject security on a watch/restricted list when the portfolio manager’s father served on the Board; (b) collect required trading reports from an investment club that the portfolio manager beneficially owned; (c) review holdings reports; (d) investigate trading in client accounts in the subject security even though the firm generally purchased mutual funds; (e) update and customize the Code of Ethics; (f) conduct an adequate annual review of the Code of Ethics; and (g) change procedures after an exam cited specific deficiencies.  The SEC cited violations of the Code of Ethics, books and records, and compliance rules.  The SEC also charged the respondent, who was also president of the firm, with failure to supervise (Section 203(e)(6)) because he did not have a reasonable cause to rely on adequate policies and procedures.
OUR TAKE: In the event of wrongdoing by a rogue employee, robust policies and procedures can be a shield against regulatory actions.   However, a weak compliance program can be used as a sword by the SEC’s Enforcement Division.  Senior executives should also take notice that the SEC will hold them accountable for failure to supervise if the firm has a weak compliance program.


Senior Execs and Firm Charged with Compliance Failures

The SEC has commenced enforcement proceedings against a large broker-dealer and two senior executives for failing to implement required compliance procedures for its sponsored access business.  The SEC alleges that the firm allowed unfettered market access to foreign trading firms without the required compliance controls relating to naked short sales, wash trades, manipulative layering, and money laundering.   The SEC says that the two executives responsible for the unit had responsibility for implementing the required compliance controls.  The SEC also alleges that the firm and the executives had adequate notice of the deficiencies after several regulatory actions against the firm’s clients, an SEC exam deficiency letter, and meetings with SEC staff.
OUR TAKE: The SEC is holding senior executives, rather than compliance staff, accountable for failure to implement required compliance procedures.  The SEC notes that the two senior executives gained financially by the business unit’s success.  In our view, the SEC is placing responsibility where it belongs i.e. with the senior executives that run the firm rather than compliance officers without a financial stake in wrongdoing.