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Month: February 2019

Signal Provider Used Misleading Hypothetical, Backtested Performance

An index signal provider, who also managed assets, agreed to a fine, censure and an outside compliance consultant for utilizing misleading hypothetical backtested performance information.  The SEC alleges that the calculations of the hypothetical, backtested performance for one of its core strategies deviated significantly from the live data, failed to conform to the firm’s model rules, and utilized an unavailable commodity index.  The SEC also faults the firm for failing to properly supervise a third-party index provider hired to create the backtested performance.  The SEC charges violations of the Advisers Act’s antifraud provisions (206(2)), advertising rule (206(4)-1(a)(5)), and compliance rule (206(4)-7). 

This case against an index provider adds fuel to the fire started by Investment Management Director Dalia Blass who last year questioned whether index providers should be exempt from investment adviser registration.  Also, as we have said before, do not use hypothetical, backtested performance information in marketing and advertising. 

Dual Registrant Lied Twice to Clients about Share Class Practices

A dually registered RIA/BD and two of its principals agreed to pay nearly $1.7 Million in disgorgement, interest and fines for recommending mutual fund share classes that paid back 12b-1 revenue sharing when lower cost shares were available.  The SEC faults the firm for failing to disclose that lower share classes were available, and that the firm and its reps made the recommendations to increase revenue rather than consider the best interests of the clients.  The SEC also criticizes the firm for neglecting to disclose that it avoided clearing broker ticket charges by recommending higher fee share classes.  After an SEC exam uncovered the wrongdoing, the firm embarked on a campaign to convert clients to lower-fee share classes, but, according to the SEC, many reps lied about the prior availability of lower-fee classes in a scheme to convince clients to pay higher advisory fees. 

Once the SEC identifies possible wrongdoing, don’t compound the problem by further misleading clients during the remediation process.  It is possible that this firm could have avoided the $400,000 in fines had it not lied to clients about its past practices.

OCIE Warns of Transfer Agent Failures to Safeguard Assets


The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert citing transfer agents for deficient safeguards and lost securityholder procedures.  Reporting on 75 transfer agent examinations over three years, OCIE observed misappropriation of shareholder funds and theft of physical certificates, inadequate account reconciliation processes, commingling of funds, and failures to secure physical access.  OCIE also observed failures to adequately search for lost securityholders including neglecting to send written notices.  OCIE recommends heightened policies and procedures, fund segregation, frequent reconciliations, locked vaults, video cameras, periodic audits, and controls around lost property.  OCIE published the Risk Alert “in order to encourage TAs to review and strengthen their applicable policies, procedures, and controls related to their paying agent operations.”

This is the regulatory warning shot for transfer agents.  Expect sweeps and enforcement actions to follow.  This Risk Alert also puts registered funds and their Boards and CCOs on notice that they should consider oversight procedures. 

Self-Reporting ICO Forced to Offer Rescission to All Investors

The sponsor of an initial coin offering agreed to offer full rescission of proceeds raised in order to settle SEC charges that the firm engaged in an unregistered securities offering.  The sponsor raised $12.7 Million by issuing digital tokens in exchange for Ether as part of its efforts to raise funds to further develop its internet security product.  The tokens would serve as currency for a peer-to-peer network that would allow participants to access additional bandwidth in the event of a cyber-attack.  As part of its marketing, principals suggested that the value of the tokens should rise as the network expanded.  The SEC maintains that this “reasonable expectation of a future profit” satisfied the Howey test and that, therefore, the tokens were “securities” and the offering constituted an unregistered securities offering.  The SEC did not impose a civil penalty because the firm self-reported. 

We don’t think that the SEC has a slam-dunk case that ICOs are securities offerings.  In fact, some courts have opined that the SEC must specifically prove that each ICO is in fact a securities offering.  Until the courts offer some specific guidance, ICO sponsors should observe the securities laws to avoid a crippling enforcement action. 

CFTC Announces 2019 Examination Priorities

The Compliance Branch of the Division of Market Oversight (DMO) of the Commodity Futures Trading Commission (CFTC) for the first time announced its annual examination priorities for contract markets and swap execution facilities.  The DMO will prioritize the following areas in 2019: cryptocurrency, disruptive trading, trading practices, block trades, markets, market makers and trading incentive programs, and relationships with service providers.  The DMO expects that most of its regulated entities will undergo at least one examination in 2019.  The CFTC expects that the DMO will announce examination priorities every year in order to enhance industry communication, prioritize risk-based areas of concern, pursue continuous improvement, and create efficiencies.

Expect the NFA to follow the DMO’s lead with respect to the announced priorities as well as the areas required in the Self-Examination Questionnaire.

Top 5 Regulatory Alerts – January 2019

Here are our Top 5 Regulatory Alerts for January 2019, ranked by significance.  We have also included the Top 5 most read Alerts.

Top 5 Regulatory Alerts – January 2019

  1. FINRA EXAMINATION PRIORITIES LETTER FOCUSES ON REGTECH AND DIGITAL ASSETS (1/23/19)
  2. ROBO FALSELY COMPARED PERFORMANCE WITH OTHER ROBOS (1/9/19)
  3. PRIVATE EQUITY FIRM OVERCHARGED CLIENTS FOR 16 YEARS (1/3/19)
  4.  RIA PLATFORM WILL PAY $1.1 MILLION TO SETTLE FUND SHARE CLASS CHARGES (1/14/19)
  5. FINRA REPORT RECOMMENDS CYBERSECURITY BEST PRACTICES (1/8/19)

 Most Read – January 2019

  1. ACCOUNTING FIRM CAUSED CUSTODY RULE VIOLATIONS (1/29/18)
  2. FINRA WHACKS LARGE BD WITH $10 MILLION FINE FOR AML COMPLIANCE FAILURES (1/25/19)
  3. FINRA REPORT RECOMMENDS CYBERSECURITY BEST PRACTICES (1/8/19)
  4. RIA PLATFORM WILL PAY $1.1 MILLION TO SETTLE FUND SHARE CLASS CHARGES
  5. PRIVATE EQUITY FIRM OVERCHARGED CLIENTS FOR 16 YEARS (1/3/19)

IT Firm Pays Over $25 Million for Bribing Foreign Officials; Execs Charged


An IT outsourcing firm agreed to pay over $25 Million in disgorgement, interest and penalties for violating the Foreign Corrupt Practices Act by paying bribes to Indian government officials to build facilities there.  The SEC and the Department of Justice have also charged the firm’s President and Chief Legal Officer with approving and facilitating the transactions.  According to the SEC, Indian officials demanded bribes to grant construction permits, and the firm approved and arranged such payments through a third-party contractor.   The SEC alleges that the firm hid the bribes by falsifying construction change orders.  The SEC charged the company on the legal theory of respondeat superior whereby the company is responsible for the actions of its senior executives.

Firms doing business outside the United States must create compliance infrastructure to prevent employees at any level from paying bribes.  Violations of the FCPA carry severe civil and criminal penalties. 

Best of the Law Firms – February 2019 edition

Welcome to the February 2019 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. 

The best law firms cranked out some great articles during the last several weeks, perhaps feeling a post-holiday burst of energy.  Paul Hastings offers a great overview of the esoteric world of Section 13 and Section 16 filings.  Morgan Lewis addresses best execution issues when recommending mutual fund share classes.  Dechert tries to discern the future of Brexit.  There were also some great pieces on co-investments from Pepper Hamilton, political and lobbying activities from K&L Gates, and a CFTC survey from WilmerHale.

SEC Reporting Obligations Under Section 13 and Section 16 of the Exchange Act (Paul Hastings)

When Best Execution Isn’t Best: Mutual Fund Share Class Selection (Morgan Lewis)

Brexit Manoeuvres: Potential Implications of a “Hard Brexit” for Fund Managers: A UK Perspective (Dechert)

Common Considerations and Complications of Co-Investments (webinar) (Pepper Hamilton)

Involuntary Termination of Investment Adviser: The Nuclear Option (Perkins Coie)

Fund Boards Are Not Immune to Activists (Skadden)

A Guide to Political and Lobbying Activities (K&L Gates)

A Year to Remember for Business Development Companies (Mayer Brown)

2018 CFTC Year-In-Review (WilmerHale)

Artificial Intelligence in Financial Services: Tips for Risk Management (Kramer Levin)

Preparing for the Next Generation of Actively Managed ETFs (Thompson Hine)

Securities Cases That Will Matter Most In 2019 (Willkie Farr & Gallagher)

Dual-Hat CCO and Weak Supervision Allowed Rogue Trader to Harm Clients

FINRA faulted a firm’s supervisory structure and unqualified Chief Compliance Officer for failing to prevent its CEO/Head Trader from engaging in a scheme that inflated bond prices to the detriment of clients.  FINRA alleges that the Trader engaged in pre-arranged trades with a third-party broker dealer to inflate and deflate bond prices to enrich both parties and circumvent an agreement with a client that capped bond commissions at 15 basis points.  FINRA asserts that the firm failed to supervise the trading and that the CCO did not have the “requisite qualifications, experience and training” to properly supervise the trading activities.  In addition to paying restitution and a fine, the firm hired a dedicated CCO that was not also working for an affiliated bank.

Broker-Dealers and advisers must abandon the dual-hat compliance model, the practice of naming a non-regulatory professional with multiple executive roles.  Firms must retain a competent and dedicated Chief Compliance Officer either by hiring a full-time employee or by retaining the services of an industry-recognized outsourcing firm.