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Month: September 2016

Principals Close Shop for Failure to Disclose Investments in Affiliated Mutual Fund

excessive fine for mutual fund

The principals of an investment adviser/fund manager agreed to wind down their firm and pay fines for failing to properly disclose conflicts of interest when they invested clients’ money in an affiliated mutual fund.  The SEC asserts the respondents invested 35% of client assets in an affiliated mutual fund, which resulted in clients paying an asset management fee of 1.3% of assets plus fund fees exceeding 2.95%.  The firm did amend its Form ADV to describe the conflict, but, according to the SEC, the respondents did not deliver the amended Form ADV to clients before investing assets in the affiliated fund.  The SEC also notes that the respondents failed to heed advice of a compliance consultant about Form ADV disclosure and delivery.  The SEC claims the respondents violated Section 206(2) (anti-fraud), Rule 206(4)-7 (compliance rule), and Rule 204-3 (brochure delivery).

The real issue in this case is that the adviser was charging clients over 4.00% in fees and expenses, which may be a breach of fiduciary duty no matter how much disclosure is provided.  The failure to deliver the Form ADV just made the case easier for SEC Enforcement.  Also, you should always listen to your compliance consultant.


Large BD Failed to Remedy Mini-Flash Crashes

Failed to Remedy Flash Crash

A large broker-dealer agreed to pay $12.5 Million to settle charges that it violated the market access rule (15c3-5).  The SEC charges that senior executives had discretion to set pre-trade controls at levels that allowed significant erroneous orders to reach the exchanges.  In several cases over a 3-year period, erroneous orders caused mini-flash crashes in the affected security.  Despite these events, which should have been red flags, the SEC faults the respondent for taking no action to address the market access until contacted by SEC staff.

OUR TAKE: This is the type of breakdown that can easily occur at large firms where compliance is left to individual business units, and no designated person has overall responsibility to monitor trading practices.


Under-Resourced Compliance Department Leads to Enforcement Action for Illegal Cross-Trading

Compliance Department

The SEC fined and censured a fund manager because its under-resourced compliance department allowed unlawful cross-trading and principal trading.  The SEC charges that the firm engaged in illegal cross-trading and principal trading between registered funds and other affiliated clients by using an interpositioned broker as part of pre-arranged transactions.  Although the firm had relevant written policies and procedures, according to the SEC, “the individuals working on cross trading within [the firm’s] compliance department were underqualified, under resourced, and required additional training and resources to effectively implement [the] trading restrictions.”  The SEC faulted the firm, and not the compliance department, because “[s]enior members of the compliance department raised the need for additional compliance resources on multiple occasions to … senior management” but those requests were not met.  Much of the relevant monitoring was delegated to a “low-level administrative assistant” because of heavy compliance workloads.

OUR TAKE: The SEC will hold management accountable for failing to properly fund the compliance function, especially after the compliance department has informed management that more help is needed.  As a guide, we recommend that firms spend no less than 5% of revenues or 7% of operating costs on compliance infrastructure, including personnel and technology.


The Friday List: 10 Characteristics of an Effective Compliance Program

Effective Compliance Program


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.

What makes a good compliance program?  It seems confusing when executive management listens to SEC speeches, interviews compliance professionals, or reads enforcement actions.  Today’s list provides the key characteristics that we examine when assessing a compliance program.


10 Characteristics of an Effective Compliance Program


  1. A qualified and dedicated Chief Compliance Officer: The CCO should have significant (at least 5 years) Advisers Act regulatory knowledge and experience.  Additionally, the CCO should be fully dedicated to the compliance function and not undertake other executive management roles.
  2. Tailored policies and procedures: The policies and procedures must be specifically tailored to the firm’s business and continually reviewed and updated.  An “off-the-shelf” manual is about as useful as internet-based medical advice.
  3. Tone at the top:  How committed senior management is to compliance can be measured by 3 key variables:  (1) total firm budget allocated to compliance (should be at least 5%); (2) executive time spent on compliance issues (at least quarterly); and (3) discipline for employees that violate compliance policies and procedures.
  4. Training and communication: A good compliance program must ensure that the entire organization has access to compliance information.  Recommended practices include ongoing training and communication.
  5. Testing and Reporting:  A firm cannot have a good compliance program without requiring its people follow the rules.  Firms must annually test all policies and procedures, record the findings and recommendations in a written report for management, and continually follow-up to ensure remediation.
  6. Compliance Calendar: A good compliance calendar will serve as the working project plan of every activity required during the year.  It should be written so that any new employee could follow the plan.
  7. Books and records:  Documentation is the hallmark of a good compliance program.  Only through well-maintained books and records can a firm log its compliance activities and demonstrate their effectiveness to senior management, clients, and the regulators.  If it’s not documented, it didn’t happen.
  8. Email review: Very little transpires in an investment management firm without email communications.  Email review can un-earth issues that annual testing may not.  Email review adds “forensic” to testing.
  9. Marketing materials: An investment firm’s marketing materials are its “canary in a coal mine” i.e. if the marketing materials are misleading or omit disclosures, very often the firm has deeper regulatory problems.
  10. Outside advisers: The best compliance programs use outside advisers to provide advice and an independent and best practices assessment.  The regulatory world has become too complicated to go it alone.

Hedge Fund Manager Faces Insider Trading and Report Filing Charges

Hedge Fund Manager

The SEC has sued a large hedge fund manager and its principal for insider trading and failure to file beneficial ownership reports.  The SEC complaint alleges that the principal used his insider status as a significant shareholder of a public company to obtain material non-public information about an impending asset sale from a senior executive who expected him to keep the information confidential.  Instead, according to the SEC, the respondents significantly increased their equity position and profited when the asset sale became public.  The SEC also charges the respondents with failing to file required Section 16 and Section 13 beneficial holdings reports over 40 times with respect to 8 issuers.

OUR TAKE: Any hedge or private equity firm that takes a significant ownership position in portfolio companies must implement controls to ensure blackout periods around material, nonpublic events.  Also, the SEC won’t accept any excuses for an investment firm that fails to implement policies and procedures to ensure timely filing of Section 16 and Section 13 beneficial holdings reports.


Best of the Web – August 2016

dealing with the SEC


Welcome to the August 2016 BOTW.  ACA does a nice job explaining how to implement GIPS, Stradley Ronon offers some strategies on dealing with the SEC, and Schulte advises on hedge fund seeding.  We have also included articles on the fiduciary rule, pay-to-play, and Brexit.  The fall is here, and with less than 4 months to make it happen in 2016, don’t let your knowledge fall behind.  “Risk comes from not knowing what you’re doing.” (Warren Buffett)


Common Practices of GIPS®-Compliant Firms (ACA)



Handling an Aggressive SEC (Stradley Ronon)



Schulte Roth Partners Discuss Hedge Fund Seeding (Schulte Roth & Zabel)



The New DOL Fiduciary Rule: Impact on Mutual Fund Distribution (Dechert)



Recent SEC Charge Underscores the Need to Scrutinize Employer-Imposed Agreements and Policies (Drinker Biddle)



Impact of Pay-to-Play Rules in the 2016 Election Cycle (K&L Gates)



“Continental Drift? Brexit’s Potential Impact on International Investment Managers” (Skadden)



Trading and Markets Enforcement Report (Morgan Lewis)



Stewart Conviction Reveals Government Blueprint for Proving Insider Trading Post-Newman (SadisGoldberg)



Significant Developments In Spoofing Cases: Coscia, 3Red and Sarao (Greenberg Traurig)



Large Audit Firm Got Too Close with Its Clients



The SEC fined a large audit firm $9.3 Million and fined and barred engagement partners because close personal relationships compromised auditor independence for 2 separate public company engagements.  In one case, the SEC asserts that the engagement partner spent over $100,000 over a 3-year period to develop a close personal relationship with the issuer’s CFO, including sharing vacation homes and going to football games.  In the other case, the SEC alleges that the engagement partner maintained a romantic relationship with the issuer’s Chief Accounting Officer.  The SEC faults the firm for failing to probe how close personal relationships could compromise independence.  The audit firm is charged with falsely asserting its independence in public filings and with violating auditing standards.  The SEC’s Director of Enforcement noted that these “are the first SEC enforcement actions for auditor independence failures due to close personal relationships between auditors and client personnel.”

OUR TAKE: This line of reasoning could also have an impact on other securities markets gatekeepers such as administrators and lawyers.  If a service provider becomes too close to its clients, can the SEC more easily assert an aiding and abetting charge if the client engages in wrongdoing?


SEC Prosecutes Securities Newsletter/Chat Room

SEC Prosecutes

The architects of an on-line stock recommendation newsletter and chat room agreed to pay $1.5 Million to settle charges that they misled subscribers.  The SEC alleges that the respondents lied about their credentials, their proprietary trading model, and performance.  According to the SEC, the respondents collected over $1.1 Million in ill-gotten subscription fees.  The SEC asserts violations of Section 10 and Rule 10b-5 for making false statements in connection with the purchase and sale of securities.

OUR TAKE: This case shows the expanding reach of the SEC to regulate non-registrants such as newsletter providers who do not receive either commissions or asset-based fees.  Using a broad interpretation of Rule 10b-5 and other rules, the SEC has pursued cases against other securities-market participants such as administrators, custodians, auditors and lawyers.


PE Firm Fined $3.5 Million and Reimburses Clients over $8 Million

conflicts of interest

The SEC fined a private equity firm $3.5 Million for engaging in several prohibited conflicts of interest.  The respondent also voluntarily agreed to reimburse investors over $8 Million.  The SEC alleges that the firm, without disclosure or approval of the LP advisory board, created a structure whereby fund investors paid organizational and operating expenses incurred in the creation of advisory affiliates.  The SEC also accuses the fund manager with allocating a disproportionate share of insurance policy premiums to the funds and for benefiting from legal fee discounts.  The SEC asserts that the firm’s failed compliance program allowed the conflicts to continue.  The firm reimbursed investors following discovery of the conflicts during an SEC exam.

OUR TAKE: Reimbursing investors after the SEC staff accuses your firm of wrongdoing won’t avoid an enforcement action or fines.  Private equity firms must implement a robust compliance program that proactively uncovers, reports, and remedies conflicts of interest