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Month: August 2019

The Friday List: The 10 Most Important Changes Required by Regulation Best Interest and Its Companions

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.

Earlier in the summer, the SEC adopted Regulation Best Interest and new Form CRS and issued interpretations of an adviser’s fiduciary responsibilities and the “solely incidental” exception to adviser registration for broker-dealers.  All-in-all, the SEC published more than 1300 pages of regulatory information.  The compliance date for Regulation BI and Form CRS is June 30, 2020.  Many firms (including ours) have authored excellent pieces describing the new rules.  However, as we do nearly every day, we will attempt to provide the most important changes for your regulatory consideration.

The 10 Most Important Changes Required by Regulation Best Interest and Its Companions

  1. Best Interest. Instead of ensuring that a recommendation is merely suitable, broker-dealers must act in the best interest of retail customers when making a securities transaction recommendation or an investment strategy.
  2. BD Disclosure. Broker-dealers must disclose (see Form CRS) material facts (e.g. fees/costs, services, conflicts, discipline) to retail customers at or before any recommendation is made.
  3. Policies and Procedures. Broker-dealers must adopt and implement written policies and procedures that address conflicts of interest (including proprietary products, sales contests, and non-cash compensation) and ensure compliance with Regulation Best Interest, which would include training, reviews, and testing.
  4. Form CRS. At or before entering into a relationship with a retail client, both investment advisers and broker-dealers must deliver new Form CRS (also filed with the SEC), which includes information about the firm’s regulatory status and obligations, fees/costs, and services.
  5. Use of “advisor”. Broker-dealers will be restricted in their use of the term “advisor” or “adviser.”
  6. Due Diligence. Advisers will have a need to conduct a greater amount of due diligence on retail clients (as compared to institutional clients).
  7. Account Monitoring. An adviser must continually monitor a retail client’s investment profile and situation to ensure that advice continues in the best interest of the client.
  8. Conflicts Disclosure. An adviser must include specific disclosure about applicable conflicts of interest and not merely describe conflicts as hypothetical or possible.
  9. Investment Discretion. Absent limiting circumstances, a broker dealer with investment discretion must register as an investment adviser.
  10. Monitoring Compensation. Receiving compensation to provide ongoing account monitoring would require investment adviser registration.

Adviser Ignored Compliance Consultant’s Supervision Recommendations


The SEC censured and fined an investment adviser for failing to supervise one of its employees who engaged in an unauthorized cherry-picking scheme.  Although the adviser had procedures requiring preclearance of personal trades, the SEC asserts that the firm failed to implement the preclearance procedures even after a third party consulting firm notified the firm of its failures to implement.  As part of the settlement, the adviser will deliver the order to each of the affected clients.

When you hire a compliance consultant, you should not ignore their recommendations.  The SEC will likely assert that you have displayed an unwillingness to implement a legitimate compliance program. 

Large Bank Hired Unqualified, Connected Interns to Secure Foreign Government Business


A large international bank agreed to pay over $16 Million in disgorgement, fines and penalties for hiring unqualified interns associated with foreign government officials in order to secure business.  The SEC asserts that the respondent violated its own policies and procedures and created false books and records to conceal corrupt transactions in violation of the Exchange Act’s books and records requirements.  The interns bypassed the bank’s “highly competitive and merit-based hiring process” and were often assigned to the very deals where a relative could steer business.  The SEC charges the bank with violating the Foreign Corrupt Practices Act over an 8-year period.

It’s never good to violate your own policies and procedures as it shows knowledge of the regulations and (at least) negligence in failing to enforce the policies.  Firms that do business overseas must create and implement procedures to ensure compliance with the FCPA.

Public Company Charged with Selective Disclosure

A public company was fined and censured for selective disclosure (Regulation FD violations).  A senior executive at the pharmaceutical company sent emails to sell-side analysts indicating positive meetings with the FDA about a drug approval, but the company did not more broadly disseminate the information within 24 hours.  On a separate occasion, the company released an 8-K that did not include the full information shared with the analysts.  Regulation FD prohibits public companies from selectively disclosing material, nonpublic information to third party securities professionals.

If this case augurs more SEC enforcement of Regulation FD, it could have a chilling effect on the information shared with buy-side asset managers, especially if the in-house lawyers and compliance personnel take an expansive view of what constitutes “material information.”  Also, asset managers should think twice before acting on what could be selective disclosure or risk a charge for aiding and abetting.

The Friday List: The 10 Most Significant Investment Adviser Proxy Voting Requirements

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.

On Wednesday, the SEC issued guidance to investment advisers about the contours of their fiduciary responsibility when voting proxies on behalf of their clients.  SEC Commissioner Elad Roisman summarized the SEC’s view: “Advisers who vote proxies must do so in a manner consistent with their fiduciary obligations and, to the extent they rely on voting advice from proxy advisory firms they must take reasonable steps to ensure the use of that advice is consistent with their fiduciary duties.”  Today, we offer the 10 most significant investment adviser proxy voting requirements.

The 10 Most Significant Investment Adviser Proxy Voting Requirements

  1. Fiduciary Responsibility. Proxy voting is part of an investment adviser’s fiduciary responsibility, which requires the adviser to vote proxies in the best interest of every client based on a reasonable understanding of the client’s objectives.
  2. Implied Duty. If the agreement with a client does not otherwise limit an adviser’s proxy voting obligations, the adviser has the implied duty to vote proxies on behalf of the client.
  3. Consider Cost of Voting. An adviser may refrain from voting if it would be in the best interest of the client (e.g. voting would impose unnecessary costs on the client.)
  4. Policies and Procedures. Advisers must adopt, implement, and test policies and procedures to ensure that the firm votes proxies in the best interest of its clients.
  5. Can’t Outsource Liability. Hiring a third party proxy firm does not relieve an adviser of its fiduciary obligations to ensure every vote is cast in the best interest of clients.
  6. Reasonable Investigation. Advisers must conduct a reasonable investigation into matters on which the adviser votes, whether or not delegated to a proxy voting firm.
  7. Client-Specific Policies. Advisers should scrutinize whether applying the same voting policy to all clients, regardless of size or type, would satisfy the fiduciary responsibility and consider client-specific policies.
  8. Corporate Actions. Significant events (e.g. corporate events, contested director elections) require a more detailed analysis than more routine events.
  9. Service Provider Oversight. Advisers must conduct a detailed initial and ongoing due diligence of third party proxy advisory firms that includes an investigation into staffing, policies and procedures, technology, and methodologies.
  10. Obligation to Update. The adviser should require the proxy advisory firm to update the adviser regarding any relevant business changes.

Withdrawing BD Registration Doesn’t Stop the SEC from Prosecuting for Failure to Supervise


The SEC fined a broker-dealer and its CEO for failure to supervise even though the firm withdrew its registration.  A broker at the firm pleaded guilty to providing inflated quotes to an investment manager as a quid pro quo for receiving future trading business.  The SEC alleges that the CEO knew that the trader provided quotes but failed to adopt and implement reasonable procedures to supervise the trader and his provision of price quotes to third parties.  The BD withdrew from registration, but an SEC Enforcement official warned, “Deregistering with the Commission in the midst of an enforcement investigation will not enable such firms to evade liability.”

Just because you abandon your car before the police can stop you doesn’t mean that you can’t get arrested.  It appears that the respondent’s efforts to avoid prosecution by withdrawing may have exacerbated their SEC problems by making them look more guilty. 

SEC Bars and Fines State-Registered Adviser for Options Cherry-Picking Scheme


The SEC barred a state-registered adviser from the industry and assessed over $400,000 in fines, disgorgement and interest for allocating options trades that benefited himself and his wife to the detriment of clients.  The adviser utilized an omnibus trading account at a third party broker-dealer to allocate profitable trades to his personal accounts and unprofitable trades to clients.  According to the SEC, during the relevant 7-month period, the personal accounts had a net positive 45.2% one-day return, but the client accounts had a net negative 45.0% one-day return, a statistically significant difference that could not be explained by random chance.  The SEC accused the adviser of securities fraud under the Securities Act (Rule 10b-5) and the Advisers Act (Section 206).

OUR TAKE: If you operate a state-registered (or unregistered) adviser, don’t assume the SEC doesn’t have the regulatory means to uncover and prosecute wrongdoing.  The feds still have jurisdiction over the securities markets and any person providing investment advice.

Firm Wrongly Relied on Inexperienced Compliance Associate


A broker-dealer was censured and fined for delegating certain regulatory obligations to an inexperienced compliance associate.  The firm filed forms with FINRA that certified due diligence about OTC issuers whose quotations it published.  The firm’s policies and procedures required the trader to conduct the necessary due diligence and a firm principal to certify the information.  In practice, an inexperienced compliance associate was tasked with obtaining the information and filing the Form 211s with FINRA by inserting the electronic signature of a principal.

This is an example of what we call compliance alchemy i.e. the appearance of compliance without actually complying.  The firm had the correct procedures and filed the right forms.  However, there was no substance behind the due diligence or the certifications.  The regulators have become wise to firms that simply check the box without actually doing the underlying compliance work. 

SEC Proposes Changes to Public Company Disclosure Regime

 The SEC has proposed significant changes to the disclosure requirements for public companies, including how a registrant describes its business, its legal proceedings and risk factors.  When describing the business (Item 101), the proposal would move to a more principles-based disclosure regime focused on material information a registrant should disclose rather than a list of topics.  The new disclosures should also include a discussion of how the management of human resources affects the business.  The proposal also would require a narrative about the effect of government regulations on a company’s capital expenditures, earnings and competitive position.  There will be a 60-day comment period following publication.

It’s always good to focus disclosure on the material issues.  However, every SEC administration trumpets a goal of “improving disclosure.”  This effort may be like putting a coat of paint on a structurally defective house to prepare it for sale.  The issue for public companies is not how the lawyers should interpret Item 101, but the onerous compliance and regulatory obligations that may discourage private and non-U.S. companies from accessing the public markets. 

SEC Judge Draws Negative Inference When Respondent Invokes Fifth Amendment

An SEC Administrative Law Judge determined to infer adverse conclusions to questions that a respondent refused to answer by invoking his Fifth Amendment privilege against self-incrimination.  The respondent refused to answer every question in the proceeding including background and foundational questions.  He also did not invoke the Fifth Amendment during the SEC’s investigation.  The ALJ explained that an administrative proceeding as well as a district court could draw such adverse inferences in order to prevent a witness from gaining an unfair litigation advantage.

The Fifth Amendment to the U.S. Constitution states that no person “shall be compelled in any criminal case to be a witness against himself” (emphasis added).  A court or an ALJ cannot make you testify if it would compromise your case in a parallel criminal action, but the judge can draw negative conclusions from invoking the Fifth.  In other words, don’t invoke the Fifth Amendment just to be petulant in front of an ALJ.  Consult your counsel to determine whether invoking the Fifth makes litigation sense given your civil and criminal predicament.