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Month: December 2018

Best of the Law Firms – December 2018 edition

Welcome to the December 2018 edition of the Best of the Law Firms.  In this feature, we recommend some of the best recent articles and analyses authored by top investment management lawyers.  These articles offer a more comprehensive review of the issues that we address in our daily “Our Take” alerts.

As the year draws to a close, the law firms have something for everybody.  We have highlighted some great articles from Groom about the fiduciary role of broker-dealers, Eversheds Sutherland addressing Chief Compliance Officer liability, and Drinker Biddle concerning the SEC’s Share Class Disclosure Initiative.  We also offer some great work about the new ETF rule (Thompson Hine), opportunity zone funds (Dechert), cryptocurrency (Morgan Lewis) and M&A (DLA Piper).

Broker-Dealers as Fiduciaries After the DOL Rule Vacatur (Groom)

Guardians of the (Compliance) Galaxy: Lessons from SEC and FINRA Enforcement Actions Against Compliance Officers (Eversheds Sutherland)

The SEC SCSD Initiative – Lessons Learned To Date (Drinker Biddle)

SEC’s Proposed ETF Rule Removes Some Conditions Compared to Prior Exemptive Orders, But Adds Others (Thompson Hine)

IRS Issues Regulations Clarifying Opportunity Zones and Opportunity Funds (Dechert)

Policing the Wild West of Cryptocurrency (Morgan Lewis)

The SEC and Digital Assets—A Busy Year End (Perkins Coie)

English and US private equity real estate funds: key features (DLA Piper)

What New Bank Charters Mean For Fintech (Ropes & Gray)

Launching Alternative Funds in Europe: Easier Than You Think (Sadis)

Deal Points Study: Representations and Warranties Insurance Continues Its Significant Influence on M&A Deal Terms (Kramer Levin)

CFTC Proposes Broader Relief for Commodity Pool Operators (Schulte Roth & Zabel)

Delaware Enacts Amendments to LLC Act and Delaware General Corporation Law (Skadden)

A Review of My 2018 Predictions

(Nostradamus, famous 16th Century soothsayer)

Every year, I offer my predictions on what will happen in the investment management regulatory world.  (I will publish my 2019 predictions next Friday.)  For 2018, I went 8-2, a record that suggests that I spend way too much time thinking about regulatory issues.   For comparison, I went 4-6 in 2017, 4-3-3 in 2016 and 6-4 in 2015.  Overall, this is not a bad record.  Below are the predictions I made last December and what happened:

A Review of My 2018 Predictions

More states will adopt fiduciary rulesMaryland and New York both adopted fiduciary rules, and it appears New Jersey is moving that direction. (1-0)

The SEC will propose a uniform fiduciary rule for retail advisers and broker-dealers.   The SEC did in fact propose a best interest standard for brokers.  I am especially proud of this prediction as I did not foresee that the Fifth Circuit would completely vacate the DoL fiduciary rule.  (2-0)

The SEC will commence significant cybersecurity enforcement actionsThe SEC fined a large internet company $35 Million for failing to disclose a third-party hack into personal customer information.  It also fined a BD/IA $1 Million for failing to prevent third parties from accessing customer information.  (3-0)

There will be cases alleging C-suite wrongdoing in private equity.  Among other actions, the SEC censured and fined the principal of a PE firm for offering below-market purchase offers to LPs and barred a managing partner for failing to disclose conflicts of interest. (4-0)

FINRA will bring actions against firms for hiring bad brokers.  There were several FINRA cases, but the most significant was an action where the SEC fined a broker-dealer $3.6 Million for failing to stop a broker from stealing from clients.  (5-0)

SEC and/or FINRA will bring cases alleging inadequate branch office supervision.  There were cases for failing to stop misleading disclosures about disciplinary histories, neglecting to implement proper AML procedures, and selling away.  (6-0)

The SEC will commence significant marketing/advertising cases.  There were several actions involving bad marketing practices including the misuse of hypothetical backtested performance, mis-representing black box quant models, and violating the testimonial prohibition. (7-0)

The SEC will propose a re-write of the custody rule.  This did not happen, although, as we said last December, it may have been wishful thinking. (7-1)

The SEC will propose cryptocurrency regulations.  The SEC has not yet proposed specific regulations, although the Division of Investment Management has asked the industry to consider valuation, liquidity, custody, and marketing of cryptocurrencies. (7-2)

The SEC will re-propose the ETF rule.  In June, the SEC proposed new rule 6c-11 would allow ETFs structured as open-end funds to operate so long as they provide daily portfolio transparency on their websites, disclose historical premium, discount and bid-ask spread information, and adopt policies and procedures about the use of custom baskets.  (8-2)

Robo-Adviser Charged with Multiple Compliance Breakdowns

 

 

The SEC censured and fined a robo-adviser for several compliance violations related to client account management and marketing.  The SEC alleges that software programming errors caused the respondent’s failure to execute tax loss harvesting without violating the wash sale rules, contrary to marketing materials.  The SEC also asserts that the firm retweeted client testimonials and other positive tweets made by those with an economic interest including employees, investors, and paid tweeters.  Additionally, the SEC maintains that the firm failed to provide the necessary disclosure to clients about payments to bloggers to refer the clients to the respondent.  The SEC charges the firm with failing to implement a reasonable compliance program in addition to violations of the antifraud rules and the recordkeeping rules.

 We think robo-advisers provide innovative services to under-served retail clients.  Regardless, as registered investment advisers, robos must conform to the heavily-regulated environment in which they operate.  Some of these alleged violations could have been easily avoided with an industry-standard compliance program.  We recommend reviewing the SEC’s previously issued regulatory compliance guidance to robo-advisers

Top 20 Regulatory Alerts – 2018

So much for calm regulatory waters.  As we look back on 2018, the SEC, contrary to many predictions, pursued a vigorous examination and enforcement agenda.  Meanwhile, the federal courts kept moving the regulatory ball in areas such as the fiduciary rule and whistleblowers.  Crypto offerings emerged as the new investment management frontier, while cybersecurity continues to worry most market participants.  Along the way, we have sought to keep you updated and informed in real time with our (nearly) daily regulatory alerts.  We have reviewed all our Alerts for 2018 and offer our list of the Top 20 Alerts of 2018.  You can decide for yourself by visiting our blog at https://cipperman.com/blog/.  If you want to dig deeper, you should read my new book The Compliance Advantage: Ten Must-Know Trends to Protect Your Investment Firm (now available on Amazon in paperback or Kindle format).

 

Top 20 Regulatory Alerts – 2018

 

  1. FIFTH CIRCUIT VACATES FIDUCIARY RULE (3/19/18)
  2. SEC FILED 32% MORE ENFORCEMENT CASES AGAINST ADVISERS AND FUNDS IN FISCAL 2018 (11/5/18)
  3. SEC RAISES CRYPTOCURRENCY FUND QUESTIONS (1/22/18)
  4. SEC PROPOSES BROKER BEST INTEREST STANDARD (4/19/18)
  5. INTERNET COMPANY PAYS $35 MILLION FOR FAILING TO TIMELY DISCLOSE HACK OF CUSTOMER INFO (4/25/18)
  6. CCOS LIABLE FOR FAILING TO “MEANINGFULLY” IMPLEMENT COMPLIANCE PROGRAMS (11/12/18)
  7. SEC FINES 13 FIRMS FOR FAILING TO FILE FORM PF (6/4/18)
  8. SUPREME COURT RULES THAT WHISTLEBLOWER MUST REPORT TO SEC (2/22/18)
  9. SEC IS EXAMINING REGISTERED FUNDS AND ETFS FOR OVERSIGHT, POLICIES, AND CONFLICTS (11/9/18)
  10. BROKER/CUSTODIAN SHOULD HAVE FILED SARS TO REPORT ADVISERS ACT VIOLATIONS (7/10/18)
  11. SEC PROPOSES ETF RULE (6/29/18)
  12. SEC PROPOSES FUND-OF-FUNDS RULE TO REPLACE ALL CURRENT EXEMPTIVE ORDERS (12/20/18)
  13. LARGE ASSET MANAGER PAYS $97 MILLION FOR OVER-RELYING ON FAULTY QUANT MODELS (8/28/18)
  14. FUND ADMINISTRATOR PAYS FOR CLIENT’S FRAUD (1/24/18)
  15. ADVISERS FAILING BEST EXECUTION COMPLIANCE OBLIGATIONS (7/16/18)
  16. SEC CHARGES VIOLATIONS OF TESTIMONIAL RULE (7/12/18)
  17. STATE SECURITIES REGULATORS REPORT SIGNIFICANT INCREASES IN CRIMINAL PENALTIES (10/11/18)
  18. FUND MANAGERS FINED FOR DISQUALIFYING POLITICAL CONTRIBUTIONS (7/11/18)
  19. SEC WANTS ADVISERS TO ENHANCE MONITORING OF ALTERNATIVE MESSAGING SYSTEMS (12/18/18)
  20. SEC ALLOWS FUND BOARDS TO RELY ON CCO FOR EXEMPTIVE RULE COMPLIANCE (10/15/18)

The Friday List: Top 10 OCIE Priorities for 2019

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.

Christmas came early this year as the SEC’s Office of Compliance Inspections and Examinations (OCIE) released its 2019 priorities, which in prior years came out in January or February.  OCIE has expanded its activities under the new Administration, boasting that it completed over 3,150 exams during the past year.  OCIE increased investment company exams by 45% and reviewed 17% of investment advisers, making good on its prior commitment to double adviser exams.  The Exam Priorities letter is long (12 single space pages) and covers many topics.  To help synthesize the data, we offer the Top 10 OCIE Priorities for 2019:

 

Top 10 OCIE Priorities for 2019

  1. Fees and Expenses:  OCIE will review disclosure and calculation of fees charged to clients.
  2. Portfolio Management: The staff will scrutinize how firms allocate investment opportunities and whether assets are managed according to stated investment objectives.
  3. New Advisers: OCIE continues to focus on never-before examined advisers and advisers that have not been examined in many years.
  4. Mutual Fund Share Classes:  The SEC will focus on which mutual fund share classes are recommended and whether reps have a financial incentive.
  5. Wrap Fee Programs: Firms must monitor wrap programs to make certain that the bundled fee is the best deal for clients.
  6. Affiliated Products/Services:  OCIE will examine the use of affiliated services or products for undisclosed conflicts of interest.
  7. Senior Investors:  The regulators are concerned about unsuitable recommendations to senior investors and supervision of reps.
  8. ETFs: The staff has prioritized ETFs with custom indexes, limited secondary market trading, and risky assets.
  9. Digital Assets: Concerned about the volatile cryptocurrency markets, the SEC remains vigilant about the sale, trading, and management of digital assets.
  10. Cybersecurity: OCIE wants firms to identify and manage cybersecurity risks including devices, governance, and policies and procedures.

SEC Proposes Fund-of-Funds Rule to Replace All Current Exemptive Orders

 The SEC voted to propose a new rule that would completely overhaul the fund-of-funds rules.  Instead of relying on exemptive orders, the new rule would allow fund-of-funds structures that meet specified conditions including: (i) limitations on voting to avoid control of the underlying fund, (ii) redemption limits within 30 days of purchasing the underlying fund, (iii) evaluations to avoid excessive aggregate fees, and (iv) prohibitions on 3-tier fund-of-funds arrangements.  The SEC would rescind all current fund-of-funds exemptive orders, thereby requiring all fund-of-funds arrangements to comply with the new rule.  Proposed Rule 12d1-4 would provide an exemption from Section 12(d)(1) of the Investment Company Act which limits an acquiring fund from acquiring (a) more than 3% of an underlying fund, (b) an underlying fund that would represent more than 5% of the acquiring company, and (c) underlying funds that in the aggregate exceed 10% of the acquiring company.  The SEC has provided a 90-day comment period.

We love the idea of an exemptive rule to allow plain vanilla fund-of-funds structures to quickly get to market without an SEC exemptive order.  We hate that the SEC will rescind all current orders, which could force many current fund-of-funds into restructuring time-tested products.  Since this is such a significant regulatory change, we expect a vigorous comment period.

Private Equity Firm Mis-Allocated Expenses and Overlooked Conflicts

 A private equity manager agreed to pay over $2.8 Million in client reimbursements, disgorgement, penalties and interest in connection with mis-allocating overhead expenses and undisclosed conflicts of interest.  The SEC accuses the respondent of allocating a portion of staff expenses to the funds without disclosure or LP committee approval.   The respondent also failed to disclose that the principal had a financial interest in two consulting firms that did work for both the funds and the manager.  The SEC asserts that the firm failed to implement a reasonable compliance program, arguing that such a claim may rest on a finding of negligence.

This is low-hanging fruit for the SEC Enforcement Division.  When you get sloppy with expense allocations and ignore interlocking financial interests, the SEC can easily make its case that the firm acted negligently by failing to implement a sensible compliance program.

SEC Wants Advisers to Enhance Monitoring of Alternative Messaging Systems

The SEC’s Office of Compliance Inspections and Examinations (OCIE) wants investment advisers to enhance procedures and surveillance for electronic messaging including texts, IM, and personal email.  OCIE advises firms to employ software to monitor social media and websites and regularly run internet searches to identify employees engaging in unauthorized online activity.  The staff also recommends that advisers either prohibit the use of personal devices or create a system to ensure that employees move messages to a system that the firm can monitor and retain.  Employees should also be required to vet personal devices with IT staff for security and message retention.

OCIE is probably correct that adviser personnel use alternative messaging systems for business communications that avoid the prying eyes of compliance.  Yet, it seems futile to require compli-pros to try to herd these cats around the internet.  Perhaps, the SEC should take a broader look at alternative messaging and the securities laws by commissioning a task force to consider practical regulations that can be followed and implemented. 

Department of Justice Allows Credit for Identifying Only Senior Execs

The Department of Justice has revised its corporate prosecution policy to allow credit to corporations that identify senior officials without identifying every individual involved.  In criminal cases, the defendant corporation must identify “every individual who was substantially involved in or responsible” for the misconduct.  In civil cases, the corporation must identify every person “who was substantially involved” to earn maximum cooperation credit.  The new policy offers prosecutors discretion over the prior policy, which according to Deputy Attorney General Rod Rosenstein, made prosecutions more difficult, time-consuming, and inefficient.  Mr. Rosenstein made clear that “pursuing individuals responsible for wrongdoing will be a top priority in every corporate investigation.”

 

 Many defense lawyers had hoped that the Rosenstein-led Justice Department would completely rescind the Yates memo, which requires the prosecution of individuals and only allows cooperation credit if companies identified the wrongdoers.  The revised policy that focuses on senior officials and those substantially involved makes practical enforcement sense but probably offers little comfort to senior executives facing off against the Department of Justice. 

Top 5 Regulatory Alerts – November 2018

  1. SEC FILED 32% MORE ENFORCEMENT CASES AGAINST ADVISERS AND FUNDS IN FISCAL 2018 (11/5/18)
  2. CCOS LIABLE FOR FAILING TO “MEANINGFULLY” IMPLEMENT COMPLIANCE PROGRAMS (11/12/18)
  3. SEC IS EXAMINING REGISTERED FUNDS AND ETFS FOR OVERSIGHT, POLICIES, AND CONFLICTS (11/9/18)
  4. FEDERAL COURT RULES THAT THE SEC MUST PROVE THAT DIGITAL TOKENS ARE SECURITIES (11/28/18)
  5. SEC WARNS ADVISERS ABOUT SOLICITATION RULE VIOLATIONS (11/1/18)

  

Most Read – November 2018

  1. CCOS LIABLE FOR FAILING TO “MEANINGFULLY” IMPLEMENT COMPLIANCE PROGRAMS (11/12/18)
  2. INSUFFICIENT COMPLIANCE RESOURCES COST FIRM AND CEO (11/8/18)
  3. SEC WARNS ADVISERS ABOUT SOLICITATION RULE VIOLATIONS (11/1/18)
  4. SEC IS EXAMINING REGISTERED FUNDS AND ETFS FOR OVERSIGHT, POLICIES, AND CONFLICTS (11/9/18)
  5. ADVISORY CLIENTS DID NOT RECEIVE PROMISED FEE BREAKS (11/20/18)