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Month: March 2019

IA Watch Compliance Conference: The CCS Summary

Three CCS professionals – Jocelyn Dalkin, Jason Ewasko and Bridget Garcia – recently attended the IA Watch’s 21st Annual IA Compliance: The Full 360° View East conference in Washington.  If you were unable to attend, you should review their summary of the most significant sessions including Dan Kahl’s summary of Enforcement Priorities, a top panel’s views on SEC rulemaking, and more specialized sessions on cybersecurity and custody.  If you want more information, feel free to contact Jo, Jason or Bridget

SEC Proposes Overhaul of BDC and Closed-End Fund Rules

The SEC has proposed an overhaul of the registration and offering rules for business development companies and closed-end funds.  The proposal provides for a shelf registration for funds with a public float of at least $75 Million and a more flexible offering and communications scheme for Well-Known Seasoned Issuers with a public float over $700 Million.  The proposal would allow interval funds to pay registration fees based on the issuance of shares rather than paying an estimate at registration.  The proposed new rules would change disclosure rules to follow operating companies, utilizing Form 8-K for significant events and management discussion of fund performance in annual reports.  A 60-day comment period will begin upon publication. 

These changes are long overdue.  The current rules shoehorn BDC and closed-end funds into the mutual fund regulatory regime, resulting in some unintended regulatory consequences.  While we’re sure that industry pros will debate the specifics of the proposal, it’s hard to argue that the SEC shouldn’t revamp the rules. 

SEC’s Blass Announces Plans to Modernize Adviser Marketing Rules

The SEC’s Investment Management Division Director, Dalia Blass, anticipates that the Division will soon recommend changes to the adviser marketing and solicitation rules.  In her annual speech to the Investment Company Institute membership, Ms. Blass also announced initiatives for a summary shareholder report, updates to the valuation guidance, modernization of the offering rules for business development companies and closed-end funds, and changes to the rules for funds’ use of derivatives.  Additionally, Ms. Blass wants the Division to finalize the proposed ETF and fund-of-funds rules.  She has also asked the staff to begin an outreach to small and mid-sized fund sponsors about regulatory barriers.  She announced that the Division is considering the formation of an asset management advisory committee to solicit diverse viewpoints on critical issues.

We applaud the reinvigorated Investment Management Division for tackling some of the thornier problems that have faced the industry for many years.  For instance, the marketing rules haven’t changed for decades despite revolutionary change in the financial services industry. 

Fund Manager Rigged Auction Process in Client Cross-Trades

A private fund and CDO manager agreed to pay over $400,000 to settle charges that it facilitated an illegal cross-trade that benefitted one client over another.  The SEC alleges that the firm sold securities held by its CDO client to its private fund at an artificially low price because the respondent failed to obtain required third-party bids.  Instead, the SEC asserts, based on a record of a phone conversation, that the firm asked friendly firms to provide false bids with assurances that they would not have to purchase the securities.  The private fund ultimately sold the securities at a significant profit.  The SEC also charged the firm’s Chief Operating Officer (who was fined and barred from the industry) for arranging the transactions and personally benefitting through his investment in the private fund.

Firms should avoid client cross-trades.  One side will always benefit, which gives rise to conflict of interest and favoritism allegations.  A fiduciary on both sides of a transaction may not be able to cure the conflict with any amount of disclosure. 

Firm’s Procedures Did Not Guide Management on How to Respond to Red Flags

A large broker-dealer was fined and censured for failing to act against a longtime broker charged with participating in pump-and-dump transactions.  The SEC faults the firm for ignoring red flags including emails outlining the illegal activity, FINRA arbitrations, and customer complaints.  One supervisor explained that he did not act more aggressively because the broker worked at the firm for 30 years and her business partner was a partial owner of the firm. The SEC asserts that the firm’s supervisory system “lacked any reasonable coherent structure to provide guidance to supervisors and other staff for investigating possible facilitation of market manipulation.”  The SEC also maintains that the firm “lacked reasonable procedures regarding the investigation and handling of red flags.”

Reasonable policies and procedures must do more than simply restate the law and the firm’s commitment to comply with the law.  The compliance manual or WSPs must specifically describe HOW a firm will prevent and address regulatory misconduct. 

Share Class Disclosure Initiative Ensnares 79 Firms for $125 Million

The SEC announced 79 settled enforcement cases whereby investment advisers agreed to disgorge more than $125 Million in the aggregate for recommending higher-cost mutual fund share classes and receiving revenue sharing.   The cases arose from last year’s Share Class Disclosure Initiative launched, which encouraged firms to self-report to avoid penalties.  The SEC charges that the firms recommended mutual fund share classes that were more costly than other available classes so that the firms or their personnel could receive 12b-1 fees in their capacities as broker-dealers or registered representatives thereof.  Each charged firm “has also undertaken to review and correct all relevant disclosure documents concerning mutual fund share class selection and 12b-1 fees and to evaluate whether existing clients should be moved to an available lower-cost share class and move clients, as necessary.”

Firms that take revenue sharing from fund companies should consult counsel about their self-reporting options.  Also, whether or not your firm self-reports, you should undertake the review of all relevant disclosure that the SEC has mandated. 

BD Fined $2 Million for Under-Resourcing Compliance Monitoring

FINRA fined a large broker-dealer $2 Million for under-resourcing its compliance function, thereby allowing unlawful short-selling.  As the firm’s trading activity increased, the firm continued to rely on a primarily manual system to monitor compliance with Regulation SHO’s requirements.  The handful of employees tasked with monitoring trading requested more resources as their 12-hour workdays could not adequately surveil the activity of 700 registered representatives.  FINRA alleges that the firm routinely violated Regulation SHO by failing to timely close-out positions, illegally routing orders, and failing to issue required notices.  As part of the settlement, the broker-dealer also agreed to hire an independent compliance consultant.

OUR TAKE: Firms need to track business activity to ensure that compliance and operations infrastructure keep up with the business.  A good metric is whether the firm spends at least 5% of revenues on compliance infrastructure including people and technology. 

SEC Alleges that RIA and Principal Ignored Compliance Obligations

The SEC has commenced enforcement proceedings against an adviser and its principal for disregarding its compliance obligations for over 10 years.  The SEC alleges that the firm did not even draft or adopt compliance procedures until an SEC examination commenced in 2015, 11 years after it initially registered.  The SEC also asserts that the principal named two individuals on Form ADV as Chief Compliance Officers even though neither person had responsibility for compliance, and one of the individuals did not even know that he was named as CCO.  The SEC also charges the firm with failing to conduct annual compliance reviews, comply with the custody rule, and maintain required books and records. 

The SEC will offer no quarter to RIAs who ignore their basic compliance responsibilities.  At a bare minimum, firms must appoint a dedicated and qualified CCO, adopt tailored policies and procedures, annually test the program, and generally attempt to comply with the Advisers Act.  The initiation of proceedings, rather than a settled order, suggests that the SEC intends to pursue aggressive penalties. 

Dual Registrant Over-Charged for Affiliated Brokerage

The acquiror of a formerly dually registered RIA/BD agreed to pay over $5.7 Million because the RIA/BD over-charged its clients for brokerage services.  The SEC maintains that the RIA/BD encouraged clients to select its affiliated brokerage program for trades because of enhanced services and pricing.  However, the SEC alleges, the RIA/BD did not provide any services that clients did not receive when selecting lower-cost brokerage alternatives, and brokerage costs were higher.  Although the firm disclosed that the affiliated broker option resulted in the RIA/BD receiving more compensation, the SEC faults the firm for failing to fully disclose that the clients would have benefited from choosing a different brokerage option.  The conflict of interest violated the antifraud provisions of the Advisers Act. 

Dual registrants that reach for revenue other than the stated asset management fee will draw the attention of the SEC Enforcement Division.  The SEC has attacked dual registrants for revenue sharing, commission splitting, and brokerage practices.  Also, firms looking to do acquisitions should understand that they can’t escape the acquired firm’s previous regulatory lapses. 

Investment Banker Used Wife’s Brokerage Account for Insider Trading Scheme

An investment banker agreed to pay over $360,000 (including disgorgement, a fine equal to his ill-gotten gains, and interest) for using his wife’s brokerage account to engage in insider trading.  As part of his settlement, the SEC dropped the charges against his wife, which it named as a relief defendant.  The SEC alleges that the defendant made trades through his wife’s brokerage account based on material non-public information learned while advising on acquisitions of two Chinese companies.  Although the alleged wrongdoing occurred outside the United States, the defendant was a United States citizen with a residence in California. 

This is why the definition of beneficial ownership for Code of Ethics reporting includes members of the immediate family sharing the same household.  Also, we question the wisdom of implicating your unknowing spouse in an insider trading scheme.