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Month: July 2016

Best of the Web – June 2016

Best of Web


Welcome to the June 2016 “Best of the Web.”  The year is half over, but BOTW is just getting started with the richest collection yet.  ACA issues its annual survey on compliance testing, Groom tries to explain the fiduciary rule, and Dechert details the new incentive compensation rule.  You should also take a look at the articles about insurance (SECCC), cybersecurity (SadisGoldberg), and carried interest (RSM).  What else do you have to do while you’re sitting on the beach?


2016 Investment Management Compliance Testing Survey (ACA)



The Final Fiduciary Rule: Impact on Investment Managers (Groom)



Incentive Compensation Back Under the Regulatory Spotlight (Dechert)



Understanding How to Mitigate Liability and Navigate Insurance Options (SECCC)



A Fund Manager’s Cyber Security Action Plan (SadisGoldberg)



How to Comply With DOL’s Best Interest Standard of Care (Drinker Biddle)



The future of carried interest (RSM)



Fee-Disclosure Pitch Would Boost Transparency, Competition (Kramer Levin)



The Challenge of Complying with Multiple and Differing Fiduciary Rules (Oyster)



Context Makes a Difference: SEC Loses Controversial Case (Willkie, Farr & Gallagher)



BREXIT: Six-Point Action Plan for Asset Managers (K&L Gates)



FinCEN Requires Financial Institutions to Obtain Beneficial Ownership Information (Morgan Lewis)



Independence and the “Loan Rule” (BBD)



Market Abuse Regulation (Ropes & Gray)


SEC Charges Fund Manager with Manipulating Inputs to Ensure Inflated Valuations


The SEC has commenced enforcement proceedings against a fund manager that it alleges used inflated valuations to ensure that the fund achieved a threshold return that allowed the respondent to withdraw cash.  Although the fund manager used a third party valuation agent, the SEC alleges that the respondent manipulated all relevant input data to ensure inflated valuations.  The SEC further argues that only the respondents had the expertise with respect to the underlying assets to know that the input data was faulty.  The SEC also charges the respondents with materially misleading investors about the fund’s assets, diversification, and risk.

OUR TAKE: Hiring a third party will not insulate unlawful acts from liability if you can control the third party or manipulate the outputs.  Investors should also understand that a third party valuation agent, administrator, or auditor does not necessarily mean that a firm is transparent.


Custody Bank Will Pay Over $380 Million to Settle FX Charges

foreign exchange

A large custody bank agreed to pay over $382.4 Million to settle charges that it misled clients about markups in FX transactions executed to settle trades.  The total amount includes disgorgement and penalties to the SEC, the Department of Justice, and the Department of Labor related to plan clients.  The amount does not include settlements with private plaintiffs in pending securities class action lawsuits.  The SEC asserts that the respondent told mutual funds and other clients that they would receive competitive market rates, consistent with best execution, on FX trades, but then “set prices driven by predetermined, uniform markups and made no effort to obtain the best possible prices for these clients.”  The SEC charges violations of the Investment Company Act for delivering misleading confirmations and transaction reports.

OUR TAKE: When charging a client any fee or expense, assume that the regulators will retrospectively scrutinize the transaction.  Always ensure full disclosure and consider foregoing the fee if disclosure cannot be made fully transparent.


Auditor Barred from Public Company Audits



The SEC fined and barred and audit firm from performing public company audits for at least one year for failing to uncover fraudulent transactions and observe professional standards.  The SEC also fined and barred the engagement partner.  The SEC alleges that the respondent ignored several red flags suggesting improper revenue recognition including efforts by management to limit audit scope, payments made by the audit client rather than its customers, internal questions raised by staff, and agreements indicating that customers would not pay.  The firm’s principals have been indicted for fraud.  The SEC barred the audit firm from accepting public company engagements until the later of 12 months or until an independent compliance consultant certifies in writing that the firm has corrected its policies and procedures.  SEC Official David Glockner admonished, “Auditors are supposed to act as gatekeepers to protect the integrity of our markets.”

OUR TAKE: A securities market gatekeeper (e.g. lawyers, auditors, administrators) cannot allow itself to become complicit in its client’s schemes by passively accepting management’s assertions and ignoring red flags that suggest unlawful conduct.


Fund-of-Funds Manager Allowed Redemptions Only to Insiders and Favored Clients

redemption gates


The SEC has commenced enforcement proceedings against a fund-of-funds manager and its principals for allowing redemptions to insiders and favored investors after telling other investors it had suspended redemptions.  The SEC alleges that the firm notified investors that it would suspend redemptions following the 2008 financial crisis.  Nevertheless, the respondents allowed over $1 Million in redemptions to insiders and preferred investors without disclosure to other investors.  The SEC charges the firm with securities fraud and breach of fiduciary duty.

OUR TAKE: A hallmark of an adviser’s fiduciary duty is to treat all clients equitably and to put client interests ahead of personal interests.  Offering liquidity to insiders while locking up others will result in litigation and enforcement.


Two RIA Firms Fined/Censured for Failing to Disclose Forgivable Loans from Clearing Brokers

clearing broker

The SEC fined and censured two registered investment advisers for failing to disclose forgivable loans received from clearing broker-dealers intended to encourage the advisers to use the brokers for clearing services.  The SEC asserts that the loans should have been characterized as revenue received from the broker-dealers, which should have been disclosed as a conflict of interest in Form ADV.  The SEC said that both actions “reflect a continued focus by the SEC’s Office of Compliance Inspections and Examinations (OCIE) and the Enforcement Division’s Asset Management Unit on undisclosed compensation arrangements between investment advisers and brokers-dealers.”

OUR TAKE:  Most advisers probably hadn’t considered forgivable loans from the clearing broker as undisclosed revenue giving rise to a conflict of interest similar to revenue sharing.  They should now.


SEC Imposes $300,000 Fine for Wrap Program ADV Missteps


The SEC fined a wrap program sub-adviser $300,000 because of Form ADV disclosure deficiencies.  According to the SEC, the respondent’s Form ADV disclosed that the firm would generally trade through wrap programs’ broker-dealers but actually made most trades through other brokers.  This trading away resulted in higher costs to investors because the trading away commissions were not included in the wrap fees.  The SEC did note that the respondent used third party brokers to obtain better execution and that the respondent did not profit in any way.  The SEC indicated that this action results from its sweep of wrap fee programs to assess “whether advisers are fulfilling fiduciary and contractual obligations to clients and properly managing such aspects as disclosures, conflicts of interest, best execution, and trading away from the sponsor.”

OUR TAKE: Take a very hard look at your Form ADV disclosures to make sure they properly represents how you truly run your business.  During exams, the SEC will spend significant time looking for disclosure inconsistencies and then impose fines for deemed insufficient or misleading disclosures.



The Friday List: The 10 Consequences of Noncompliance and SEC Enforcement

the list


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.  Today, we address the 10 implications for a firm that faces an enforcement action as a result of a failure to implement a competent compliance program (either intentionally or unintentionally).


Consequences of Noncompliance and SEC Enforcement


  1. Financial penalties: The most obvious direct consequence of an enforcement action include the financial penalties that the SEC can impose.  These can include fines, interest, and restitution for “ill-gotten gains” going back several years.
  2. Industry bars: Rarely does an SEC action not name one or more of the firm’s principals.  And, if successful, the penalties usually include fixed or permanent industry bars, thereby precluding you from making a living in your chosen field.  If the permanent bar includes a firm principal, it could mean the end of the firm itself.
  3. Lost management time: Responding to, and defending, SEC enforcement actions consumes hundreds of hours of management time dealing with lawyers, assembling materials, meeting with employees, and testifying.  This is time lost to the productive activities required to run your business.
  4. Defense Costs:  The costs of lawyers retained at high hourly rates to defend enforcement actions very often far exceed any fines or disgorgement that the SEC imposes.
  5. Reputation – competitive (dis)advantage:  Don’t think your competitors won’t highlight a public enforcement action during every RFP and competitive client situation.   Additionally, many institutional investors automatically disqualify money managers with a regulatory record.
  6. Impact on commercial value: A potential buyer will discount a firm’s equity value because of public regulatory issues that could impact its long-term competitiveness.
  7. Criminal prosecution:  The SEC has the power to refer cases to the Department of Justice.  As a result of such referrals, especially when fraud or misuse of asset is alleged, the DoJ has prosecuted and imprisoned many financial executives.
  8. Increased examination focus: Once the SEC has brought an action, expect the staff to appear for regulatory exams on an accelerated, if not continuous, cycle.  It’s the SEC’s job to weed out recidivists.
  9. Insurance Costs:  Following an enforcement action, E&O and D&O rates will rise significantly, assuming you can even obtain such coverage.
  10. Hiring: In the war for talent, a bad reputation will repel the best and brightest who have multiple opportunities.

OCIE Launches Share Class Initiative

no load funds

The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert announcing its Share Class Initiative, which will examine how advisers recommend mutual fund and 529 share classes.  The Risk Alert indicates that the exam staff will review whether an adviser has satisfied its fiduciary duty and best execution obligations when recommending a more expensive share class when a less expensive share class of the same fund is available.  OCIE will also scrutinize load and distribution compensation received through affiliates and whether such compensation arrangements are properly disclosed in Form ADV Part 2.  Also, the exam staff will review relevant compliance policies and procedures concerning the share class selection and recommendation process.  In the Risk Alert, OCIE “encourages advisers to reflect upon their own practices, policies, and procedures in these areas and to make improvements in their advisory compliance programs where necessary.”

OUR TAKE: Compli-pros should review any recommendations of share classes that carry a load or distribution fee (including 12b-1 or shareholder servicing fee).  An adviser who recommends such share classes will have the burden of defending why it didn’t recommend a less expensive share class.