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Month: June 2019

Large Custody Bank to Pay $89 Million for Marking Up Out-of-Pocket Expenses

A large custody bank agreed to pay almost $89 Million in fines, disgorgement, and interest to settle charges that it overcharged investment company clients by marking up purported out-of-pocket expenses for nearly two decades. The most significant markups occurred on SWIFT messages as the bank failed to adjust the charges as its internal costs decreased over time. The SEC also maintains the bank overcharged investment company clients on 12 other classes of expenses, collecting $170 Million in profit during the period. The SEC charges the custody bank with causing its fund clients to maintain inaccurate books and records.

This case should prompt fund financial officers to review the charges imposed by the custody bank. That nickel and diming on everything from wire fees to foreign custody reports may be unlawful. Service providers should also take note that the SEC will initiate enforcement for overcharging registrants even where the service provider itself is not an SEC registered or regulated entity.

Massachusetts Proposes Its Own Fiduciary Rule

The Massachusetts Securities Division has proposed a fiduciary rule for all brokers and advisers for the provision of recommendations, advice and selection of account type. The proposed rule would require that all recommendations and advice be made in the best interest of customers and clients without regard to the broker/adviser’s interests. The MSD asserts that the suitability standard has not sufficiently protected customers against sales contests, churning, risky products and bad brokers. The MSD also criticizes the SEC’s recently adopted Regulation Best Interest because it (i) does not fully protect investors; (ii) relies too much on disclosure; and (iii) does not resolve customer confusion about the applicable standard of care. The MSD is accepting comments until July 26.

The expansive MSD proposal includes any type of financial adviser, any type of customer, and any type of advice. If adopted, the MSD’s rule would set up a court case about whether Regulation Best Interest preempts state fiduciary rules.

No-Action Relief for Diversified Index Funds and ETFs

The SEC staff has granted no-action relief to allow index funds to become non-diversified as a result of market changes to the underlying index components. Without the relief, an index fund that tracks a third-party index would have to obtain shareholder approval to change its status from diversified to non-diversified when certain underlying component securities increased in value such that they would make up more than 5% of the portfolio. The relief would require prospectus disclosure that the fund could become non-diversified during these periods. The fund would still be constrained by the diversification requirements of the tax code and the applicable exchange on which it is traded.

This issue has dogged large index funds and ETFs for the last couple of years as the FAANG securities have increased in market value as compared to other index components. This letter offers welcome relief.

Large Firm Will Pay Over $280 Million to Settle FCPA Charges

A large retailer agreed to pay more than $282 Million to settle charges brought by the Department of Justice and the SEC that it failed to implement anti-corruption procedures required by the Foreign Corrupt Practices Act. The prosecutors assert that the company knew about FCPA violations including unlawful payments routed through intermediaries as far back as 2000 but failed to take any meaningful action until 2011. Alleged failures included neglecting to follow up on obvious red flags raised by the internal audit function, revising internal recommendations, delegating compliance to in-country business units, and failing to implement sufficient training. An SEC enforcement official maintains that the company “valued international growth and cost-cutting over compliance.”

The Foreign Corrupt Practices Act requires registrants to implement rigorous compliance and internal controls to prevent unlawful payments to foreign government officials. Violations can result in substantial civil and criminal penalties.

SEC Considering Changes to Private Offering Rules

The SEC has issued a Concept Release that requests comment and input on possible changes to the offering rules including the “accredited investor” definition and the use of private funds to raise capital. With respect to the “accredited investor” definition, the SEC asks for input on whether it should (i) revise financial thresholds for qualification; (ii) add categories of qualifying investors based on prior experience, professional credentials, or an examination; and/or (iii) measure accreditation based on amount of investments rather than income. For private funds, the SEC wants input on whether it should (i) include 3(c)(7) (qualified purchaser) funds within the definition of “accredited investor” and (ii) change the definition of qualified client for purposes of taking performance fees. The SEC is also considering changes to Regulation D private placements, Regulation Crowdfunding and secondary trading rules.

We believe that the SEC should expand the “accredited investor” definition and allow broader use of private pooled funds for capital raising and investment. However, we have been here before in 2017, 2013, and 2010. Let’s hope Chairman Clayton, who focuses on capital raising, can make true reform happen this time.

Big 4 Firm Fined $50 Million for Stealing Exam Answers

The SEC fined a Big 4 audit firm $50 Million for misappropriating information from the PCAOB concerning impending inspections. Several members of firm management were also terminated and charged. The firm obtained the confidential exam information from employees that previously worked at the PCAOB as well as PCAOB employees being recruited by the firm. Information included lists of audit engagements that the PCAOB planned to inspect, specific criteria used for the inspection, and the focus areas. The SEC alleges that the firm also reviewed and revised work papers to avoid deficiencies. Separately, the firm was also charged with sharing answers and adjusting scores so that internal personnel could more readily pass internal continuing education courses. The SEC charges the firm with failing to comply with ethics and integrity standards, AICPA conduct rules, and PCAOB quality control standards. In addition to the fine, the firm agreed to retain an independent consultant.

The SEC relies on the securities markets gatekeepers, such as the large audit firms, to police the industry. When the gatekeepers act without integrity, it undermines the SEC’s ability to protect investors. This case once again raises the issue whether government officials should observe a cooling-off period before going to work for the companies they previously regulated.

Best of the Law Firms – June 2019 edition

Welcome to the June 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 law firms continue to offer up some great articles for the investment management industry. We have included several year-end litigation and trend reviews from Morgan Lewis, Stradley Ronon, and Willkie Farr. We also like the analyses of new products including interval funds (Ropes & Gray), opportunity zone funds (K&L Gates), cannabis (Kramer Levin), and litigation finance (Schulte Roth). There are some other great pieces of work about hedge fund seeding (Seward & Kissel) and DoL investigations (Groom).

2018 Year in Review: Select SEC and FINRA Developments And Enforcement Cases (Morgan Lewis)
SEC Enforcement Developments of Note for Mutual Funds and Their Advisers: The Year in Review and a Look Ahead (Stradley Ronon)
SEC Enforcement Against Private Equity Firms in 2018: Year in Review (Willkie Farr & Gallagher)
Opportunity Zone Funds: Key Considerations for Private Fund Managers—Part 1 (K&L Gates)
Pitfalls To Avoid As Cannabis M&A Takes Off (Kramer Levin)
Credit Funds: 1940 Act Interval Funds (podcast) (Ropes & Gray)
What a fund manager should know about entering the litigation finance industry (Schulte Roth & Zabel)
Seed Transaction Deal Points (Seward & Kissel)
Mutual Fund Performance Fees: Perspectives After More Than 40 Years (Dechert)
US v. Connolly and the potential pitfalls of cooperation in internal investigations (DLA Piper)
SEC Approves First Nontransparent, Actively Managed ETFs (DrinkerBiddle)
What Is a DOL Adviser Investigation Like? (Groom)
Something Familiar, Something New: OFAC’s Compliance Program Framework (Paul Hastings)
Compliance Officers Should be Shaking in Their Boots (Eversheds Sutherland)

Frat Bro Ran Ponzi Scheme

The SEC charged a University of Georgia undergraduate with running a Ponzi scheme out of his fraternity house. The SEC asserts that he utilized group texts to solicit others associated with the university to invest in a hedge fund which did not exist. He also used on-line cash applications as a means for one investor to send money to other investors to further his scheme. The respondent touted high historical returns and false credentials. The SEC contends that the respondent used the funds for personal expenses including gambling junkets and adult entertainment.

Affinity-based Ponzi schemers will use their positions of trust to swindle funds from the naïve and unsuspecting. In this case, the tools may be new (group texts, cash apps, fraternity), but the con job is as old as the securities markets. Tell your friends and family not to give money to anybody without checking the SEC website and making sure the “manager” is registered.

SEC Adopts Regulation Best Interest, Raising Broker Standard of Care

The SEC adopted Regulation Best Interest for broker-dealers that make recommendations to retail clients. Regulation Best Interest, intended to enhance a broker’s standard of care beyond suitability, requires a broker-dealer to act in the retail customer’s best interest and to refrain from transactions that favor the interests of the broker over the customer. The new rule requires disclosure as well as policies and procedures to ensure that brokers identify and mitigate conflicts of interest. The SEC also adopted new Form CRS that requires both advisers and brokers to provide retail customers with standardized information about their relationship, including services, fees, conflicts, standard of conduct, and disciplinary history. The SEC also issued an interpretation that addresses an adviser’s fiduciary responsibilities. Part of this regulatory package includes a refining of the “solely incidental” exception to adviser registration for brokers. Firms have until June 30, 2020 to comply with Regulation Best Interest, although the new interpretations apply immediately upon publication.

Let’s rename this “The Compliance Officer Full Employment Act.” Compli-pros at broker-dealers will have to rework all of their Written Supervisory Procedures, revise client agreements, create disclosures, and eliminate all prohibited conflicts. Compliance offices at investment advisers must address the new Form CRS requirement and implement new client onboarding procedures while figuring out the changes required by the investment adviser fiduciary interpretation. And, we only have 12 months to get this all done.