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Month: May 2018

Thompson Hine and Cipperman Podcast Identifies Top Regulatory Issues

Cassandra Borchers, a partner at Thompson Hine, and Todd Cipperman recently sat down to discuss the 10 most significant regulatory trends for the investment management industry.  In their podcast, Todd and Cassandra discuss an investment adviser’s fiduciary responsibilities, including Regulation Best Interest and wrap programs, senior executive liability, service provider accountability, compliance programs, whistleblowers, and cybersecurity.  Their conversation is based on Cipperman’s upcoming book that delves deeper into these Top 10 investment management regulatory trends.  Thompson Hine LLP, a full-service business law firm with approximately 400 lawyers in 7 offices, has received numerous awards for innovation, service and expertise.  Cipperman Compliance Services leads the investment management industry in providing outsourced compliance services.


Hedge Fund CFO Barred and Fined for Unauthorized Money Movements

The former Chief Financial Officer of a now-defunct hedge fund was fined and barred from the industry for authorizing improper inter-fund transfers and other financial improprieties.  The SEC alleged that the CFO authorized the ongoing transfers of funds from an affiliated offshore fund to facilitate the activities of a cash-strapped on-shore funds.  The CFO continued the practice even after two subordinate accountants resigned after complaining that the practice did not comport with the funds’ governing documents or applicable accounting standards.  The SEC accused the CFO with aiding and abetting his firm’s activities that defrauded investment advisory clients.

OUR TAKE: The SEC will seek to hold individual officers accountable for the illegal actions of the firms they manage.  The SEC’s Enforcement Division has cited personal accountability as a core enforcement principle.


SEC Proposes New Fund Research Reports

The SEC has proposed a new rule that would allow third party broker-dealers to publish research reports about registered investment companies without having to comply with current performance presentation requirements.  Proposed Rule 139b would allow a broker-dealer that is not affiliated with the fund’s adviser to publish research reports that meet certain presentation requirements even where the broker-dealer participates in the offering.  A similar safe harbor already exists for other issuers.  The SEC seeks comment about whether performance information should be required to comply with Rule 482’s performance presentation requirements currently applicable to fund advertising.

OUR TAKE: We would go a step further and rewrite Rule 482 to allow more flexibility for all fund materials.  Then, the SEC would not have to wrestle with whether to allow different types of fund reports depending on the preparer, which could result in more confusion.


Broker-Dealer Fined for Failing to Produce Emails

The SEC fined and censured a broker-dealer for failing to produce requested emails as part of an enforcement investigation related to potential money laundering activities.  Despite repeated requests, the respondent could not produce emails for a 4-month period relevant to the subject activity.  The firm initially represented that it produced all required emails, but ultimately found 40,000 missing emails from 30 employees maintained on a back-up email archive.  The SEC noticed that the document production omitted emails from the correspondent firm through which the potential money laundering activity occurred.  Rule 17a-4(j) of the Exchange Act requires broker-dealers to promptly furnish to the SEC any required records.  The SEC also charged the firm with failing to file Suspicious Activity Reports.

OUR TAKE: Don’t tell the SEC that you have complied with their document requests unless you have conducted adequate internal due diligence.   The Enforcement staff will not look kindly on reckless or intentional misrepresentations during investigations.  Also, lying to the staff can result in criminal penalties.


The Friday List: 10 Things You Need to Know About Regulation Best Interest

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.

A few weeks ago, the SEC proposed Regulation Best Interest, which requires a broker to act in the best interest of each retail customer at the time the recommendation is made, notwithstanding the broker’s own financial interests.  The SEC has been pondering a broker fiduciary rule for many years but lost the regulatory race to the Department of Labor, which promulgated its own rule.  Now that the 5th Circuit has vacated the DoL Rule and the SEC has proposed its own rule, the current state of the law is unclear.  Regardless, we have read the release and offer our list of the 10 things you need to know about proposed Regulation Best Interest.

10 Things You Need to Know About Regulation Best Interest

  1. Reasonable basis.  A broker must have a reasonable basis that the recommendation is in the best interest of the client.
  2. Applies to retail customers.  A retail customer is defined as a person who uses the recommendation primarily for personal, family, or household purposes.
  3. “Recommendation” remains the same.  The proposal does not seek to change the definition of “recommendation,” preferring to defer to the current FINRA interpretations.
  4. No definition of “best interest”.  In 400+ pages, the SEC never defines the term “best interest” when proposing Regulation Best Interest.
  5. More than suitability, less than fiduciary.  Regulation Best Interest combines elements of the current suitability standard (e.g. suitable at time of transaction) with a few fiduciary-like elements (e.g. disclosure).
  6. Fails to harmonize RIA and BD standards.  Advocates of a uniform fiduciary standard want a single standard so that consumers are not confused by the differing standards of care applicable to advisers vs. brokers.  This proposal fails to ensure a “uniform” standard.
  7. Disclosure of conflicts of interest.  The most significant new requirement is that brokers must disclose (or mitigate) conflicts of interest.
  8. Must consider series of transactions.  Expanding traditional suitability, a broker must also consider the series of recommended transactions.
  9. Product neutrality not required.  Brokers can make more money on recommended products, including proprietary products, so long as the conflict is properly disclosed and mitigated.
  10. Regulation Best Interest is not law.  Comments are due on this controversial proposal by August 7, 2018.  Thereafter, we expect much debate and re-drafting before any final rule is adopted.

CCO/AML Officer Barred and Fined for Failure to File SARs

The SEC fined and barred a CCO/AML Officer from the industry for failing to file Suspicious Activity Reports and otherwise ignoring his AML due diligence responsibilities.  The SEC accuses the CCO/AML Officer and his firm with ignoring clear red flags that suggested significant churning of penny stocks.  Red flags included questionable customer backgrounds, absence of a business purpose, multiple accounts with the same beneficial owners, rapid transactions, and law enforcement inquiries.  The firm sold over 12.5 billion shares of penny stocks over a 9-month period.  The SEC also charged the firm and its clearing firm.

OUR TAKE: While we certainly don’t condone the CCO’s inactions here, why is he the only executive officer charged?  Also, the respondent’s problems may have only just begun as FinCEN can impose a $25,000 fine on the CCO/AML Officer for each failure to file an SAR.


FINRA Requires Heightened Supervision over Bad Brokers

FINRA has outlined recommended heightened supervisory procedures for brokers with a history of past misconduct. FINRA suggests that firms should (i) designate a principal with supervision responsibility; (ii) provide specific training to the bad broker; (iii) require written acknowledgements; and (iv) conduct periodic reviews of the plan’s effectiveness.  FINRA also describes certain characteristics of an effective heightened supervisory plan: physical proximity of the supervisor to the broker, ongoing contacts and reviews, frequent monitoring, and expediting customer complaints.   FINRA has also proposed rules that would subject member firms that hire bad brokers to additional FINRA monitoring and reporting.

OUR TAKE: FINRA wants to make it difficult on firms that hire brokers with a disciplinary record by imposing additional regulatory, monitoring and reporting requirements.



Lawyer Charged with Preparing Misleading Registration Statement

The SEC has sued a lawyer for aiding and abetting securities fraud by preparing a registration statement that failed to disclose that the principal was a convicted felon that controlled the issuer.  According to the SEC, the principal instructed the lawyer that he should not be named as an officer or director of the issuer because of his prior conviction.  Nevertheless, according to the SEC, the lawyer knew that the principal fully controlled the issuer and failed to include such disclosure in the Form S-1.  The SEC also charges that the lawyer knew or was severely reckless in not knowing that the three persons listed as officers and directors had not agreed to serve.

OUR TAKE: The SEC will hold gatekeepers, including lawyers, accountable for their bad clients.  This case goes further than prior enforcement cases by prosecuting a lawyer for reckless conduct rather than knowingly furthering a specific fraud.


Performance Track Record No-Action Letter Will Help Adviser M&A

The staff of the Division of Investment Management has granted no action relief to allow a merged subsidiary to continue to use its performance track record.  The SEC noted that the internal reorganization described would result in a newly-created division utilizing the same investment personnel and processes.  The applicant, which merged the former separate entity into another investment adviser subsidiary, distinguished the reorganization from the Great Lakes no action letter, where the SEC came to a different conclusion because the new investment committee had personnel changes.

OUR TAKE: This letter will help investment adviser roll-ups by private equity firms and other strategic buyers by allowing internal corporate structuring freedom without fear of losing performance track records.


SEC Charges Hedge Fund Firm with Inflating Valuations to Slow Redemptions

The SEC has charged a hedge fund firm and its principals with using false broker quotes and imputed valuations to inflate the value of securities.  Facing significant investor redemptions and underperformance versus peer funds, the SEC claims that the principals expressed concerns about going out of business.  In response, the SEC alleges, the respondents engaged in a scheme to obtain inflated broker quotes from a broker to whom they promised additional business.  In addition, the SEC avers that the respondents used imputed mid-point prices to value securities, contrary to statements made in offering documents.  Ultimately, the fund’s auditor questioned the valuations and refused to complete the audit.

OUR TAKE: Bad things happen when firms face failure.  Many enforcement cases arise from firms and managers that desperately try to cut regulatory corners to avoid firm collapse. It is better to accept defeat than to try to rescue your career after the SEC names you in an enforcement case.