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Month: January 2018

Top 5 Regulatory Alerts – December 2017


Here are our Top 5 Regulatory Alerts for December 2017, 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 – December 2017



Most Read – December 2017


Adviser Borrowed From Clients without Full Disclosure of Financial Condition

The SEC censured and fined an investment adviser and its two principals for failing to disclose the firm’s weak financial condition to retail investors, including advisory clients, to whom it sold promissory notes.  As far back as 2012, the advisory firm struggled financially as its inability to raise assets and earn fees failed to offset rising operating costs. To keep afloat, the firm issued short-term promissory notes to retail investors including its advisory clients.  The SEC faults the firm for failing to disclose its weak financial position and the significant risk that it would not repay the notes (even though it did not default on any interest payment).  The SEC cites violations of the Exchange Act’s and Advisers Act’s antifraud rules.

OUR TAKE: The SEC can assert regulatory violations even where there is no client or investor harm.  Here, the SEC filed a settled enforcement action related to concerns about the notes even though the adviser never actually defaulted.  Adviser should also note that Item 18.B. of Form ADV requires disclosure of any “financial condition that is reasonably likely to impair your ability to meet contractual commitments to clients.”


The Friday List: Top 10 Cryptocurrency Fund Regulatory Concerns

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.

Last week, the SEC’s Division of Investment Management asked sponsors to refrain from initiating registrations for funds investing in cryptocurrencies and related products.  Dalia Blass, the Division Director, cited “significant outstanding questions” about how such funds could comply with applicable laws and regulations.  In today’s Friday List, we describe the top 10 regulatory concerns raised by the Division of Investment Management.  Despite these concerns, we believe that the SEC and the industry will work through these issues and develop rules and best practices that will ensure the growth of this market in a manner that engenders investor confidence.


Top 10 Cryptocurrency Fund Regulatory Concerns


  1. Valuation: The SEC asks whether funds could obtain sufficient information to properly value fund assets pursuant to current accounting rules especially given the “nascent state and current trading volume” in the futures markets.
  2. Liquidity: Could funds reduce crypto-assets to cash so as to meet daily redemption requests?  How would funds classify assets under the SEC’s new liquidity rule (22e-4)?
  3. Custody: The SEC questions how a fund custodian could validate the existence and ownership of cryptocurrency assets, and how funds would address physical security where applicable.
  4. ETF Creation: Will the creation unit process operate in a way that ensures that funds and authorized participants limit arbitrage opportunities that harm investors?
  5. Volatility: The limited history and volume of the cryptocurrency markets could negatively impact fund operations and affect investors.
  6. Lack of regulation: Neither cryptocurrency markets nor providers/issuers are subject to prudential regulation.
  7. Market manipulation: The SEC cites Chairman Clayton’s concerns over market manipulation and potential fraud.
  8. Cybersecurity:  Could a potential hack threaten ownership interests and valuation?  What safeguards are in place?
  9. Disclosure:  How would fund sponsors ensure sufficient risk disclosure and transparency in fund prospectuses and other shareholder communications?
  10. Suitability:  How will broker-dealers and advisers ensure their suitability and fiduciary obligations when recommending crypto-funds to retail investors?

Fund Administrator Pays for Client’s Fraud

A fund administrator agreed to pay over $560,000 to settle charges that it caused its client’s violations of the Advisers Act’s antifraud provisions.  The client defrauded clients (and ultimately went to prison) for misappropriating client assets by creating fake loans in which the fund invested.  The fund’s custodian declined to book the fake loans because they lacked sufficient backup documentation.  Regardless, the administrator included the loans in the fund’s NAV even though, according to the SEC, it knew that the custodian excluded the loans.  The SEC faults the administrator for failing to further investigate, notify the board or shareholders, or exclude the loans from the NAV calculation.

OUR TAKE: Although it may be a legal stretch to assert that a fund administrator caused a fraudulent client’s illegal conduct, the SEC will hold securities markets gatekeepers accountable for their client’s behavior.  Service providers must conduct due diligence before accepting a client or risk being found guilty by association.


Managing Director used Prop Account to Trade Directly with Advisory Clients

The Managing Director of an IA/BD was censured and order to pay disgorgement and a fine for trading with his advisory clients out of a proprietary account without advance notice and consent.  The respondent arranged over 2,700 principal trades between his clients and a proprietary account over which he had trading authority.  The SEC asserts that he knowingly failed to provide the required disclosure about the mark-ups received as well as obtain the advance consent to engage in principal transactions.  FINRA previously barred his former firm from the industry in connection with churning allegations.

OUR TAKE: Although the regulators barred his firm, they did not stop there.  The SEC will hold individuals accountable for their firms’ legal violations especially if they participated and benefited.


SEC Raises Cryptocurrency Fund Questions

The SEC’s Division of Investment Management sent a letter to the ICI and SIFMA listing the “significant outstanding questions” concerning how proposed registered funds investing in cryptocurrencies and related products would satisfy the Investment Company Act.  The letter, signed by Division Director Dalia Blass, warned potential fund sponsors against initiating fund registrations until these questions “can be addressed satisfactorily.”  The letter questions how funds would value cryptocurrencies and related products given their volatility and lack of regulation.  The Division also questions liquidity and whether funds could meet daily redemption requests.  The letter also raises custody concerns, asking how funds could “validate existence, exclusive ownership, and software functionality.”  ETFs pose additional questions related to authorized participant and arbitrage processes.  The letter also asks about distribution and fiduciary duty.  The Division expressed its willingness to “engage in dialogue with sponsors regarding the potential development of these funds.”

OUR TAKE: We believe that both the industry and the SEC have vested interests in coming to an agreement to allow cryptocurrency offerings.   The industry should welcome prudent regulation, which gives investors the type of confidence that made mutual funds so successful.  The SEC should get out in front of this issue to become the regulator of choice rather than cede its regulatory authority to offshore, non-U.S., and private markets.


Best of the Web – January 2018 Edition

Welcome to the January BOTW, covering articles from November-December.  Cryptocurrency and ICOs are hot, hot, hot.  Check out the podcast by Pepper and the regulatory article from Seward & Kissel.  Also included are the materials from the well-respected K&L Gates annual investment management conference.  We love ACA’s title about wrap programs and Cohen’s piece about management fee waivers.


Materials from the 2017 Investment Management Conferences (K&L Gates)

Top cybersecurity trends for 2018 (Cordium)

A Review of Initial Coin Offerings (podcast) (Pepper Hamilton)

The Hot Money: Cryptocurrencies and Implications for Investment Advisers (Seward & Kissel)

Management Fee Waivers: Potentials and Pitfalls for Fund Advisors (Cohen & Co.)

Regulatory Scrutiny on Wrap Fee Programs – Not Such a Wrapper’s Delight (ACA)

Q&A: What to Expect from the “New” SEC (Ropes & Gray)

The Future of FinTech Part 1 and Part 2 (podcast) (DLA Piper)

Nominating Committee Best Practices (podcast) (Thompson Hine)

Plan Sponsor Fee Litigation Cases on the Rise (Groom)

The Duty of Diligent Supervision: To Whom And What Does It Apply And What Does It Require? (Willkie Farr & Gallagher)

SEC Fines and Bars Two Advisers for Selling Away Private Equity Fund

The SEC fined and barred two advisers for selling interests in a private equity fund to their clients away from their broker-dealer and other securities law violations.  The defendants operated a branch office of a registered IA/BD and held licenses.  However, the SEC asserts that they formed the private equity fund and sold interests therein without the knowledge or consent of the BD.  The SEC maintains that the selling activity constituted unregistered broker-dealer activity because they acted outside the scope of their employment and their mere association with the broker-dealer did not cover their activities.  The SEC also charges the pair with other securities laws violations including misrepresentations and conflicts of interest.

OUR TAKE: Individuals that sell private fund securities must obtain appropriate securities law licenses and submit to broker-dealer supervision.  Just having a Series 7 does not give you carte blanche to engage in any securities activity unless your broker-dealer approves and supervises.


Bank-Affiliated BD Hit with a $13 Million Fine for AML Monitoring Flaws

The SEC fined a large bank-affiliated broker-dealer $13 Million for weaknesses in its anti-money laundering program and for failing to file suspicious activity reports over a 5-year period.  The SEC faults the firm for utilizing a patchwork monitoring system across its large enterprise that often failed to monitor certain accounts and uncover potential money laundering activity.  The SEC raised specific concerns about transactions in brokerage accounts that utilized banking services such as ATMs, check-writing, and wire transfers.  The firm also failed to quickly remedy some of the AML monitoring issues that it self-identified.

OUR TAKE: As firms get larger (especially through acquisition), account monitoring and AML management becomes much more difficult.  Larger firms should consider appointing an enterprise-wide AML czar to take control of all monitoring activities.


SEC Issues FAQs on Liquidity Risk Management Rule

The staff of the SEC’s Division of Investment Management has released FAQs for the new Liquidity Risk Management Rule for open-end funds and ETFs (Rule 22e-4).  Most significantly, the staff will allow funds to delegate liquidity program responsibilities to a sub-adviser either in whole or in part “subject to appropriate oversight” including relevant policies and procedures.  The staff also clarifies that the same investment may carry different liquidity classifications by different advisers or funds, provided the liquidity program properly supports the classification.  The FAQs address several technical issues for in-kind ETFs.

OUR TAKE: Many industry participants acknowledged the broad policy goals of the liquidity rule but questioned the rule’s practical implementation.  The FAQs help that process by addressing some of the outstanding questions.