The SEC’s Division of Trading and Markets has provided limited period no-action relief to beta test a service that will allow securities clearance using a distributed ledger system. The 24-month relief would allow the applicant to operate a securities settlement service whereby securities and cash would be represented by digitized securities entitlements that would be exchanged in accordance with the underlying securities transactions. Without no-action relief, the applicant would have to register as a clearing agency. The SEC is allowing limited testing of the system without registration so long as the applicant follows strict guidelines that limit use of the system and volume.
The use of distributed ledger technology and digital tokens could revolutionize securities settlement and transfer agency processes. Securities settlement could happen more quickly with fewer transaction costs. The SEC (and the applicant) deserve credit for allowing this testing period before requiring full-blown registration.
The SEC instituted proceedings against a private fund manager and its principals for inflating the valuation of illiquid assets and conflicts of interest. The SEC charges that the defendants marketed a fund with the term “income” in its name even though the fund held only illiquid assets including a private company and interests in gems and minerals. The SEC also asserts that the defendants inflated the values of the fund’s assets in order to pay their management fees while telling investors that the fund lacked liquidity to meet redemption requests. The SEC claims that the defendants illegally paid themselves more than $13 Million in management fees. The SEC also asserts that the principals engaged in self-dealing insider loan transactions and invested client money in their affiliated funds.
Fund sponsors claiming limited liquidity or redemption gates make want to re-consider how and when to pay management fees especially based on assets that are not publicly traded. Also, private fund sponsors should review fund names and offering documents to make sure they remain accurate over time.
The U.S. Attorney for the Eastern District of New York has indicted the former Chief Compliance Officer of a private equity firm for obstructing justice and illegally accessing confidential government information. According to the indictment and press accounts, the defendant misused his position and access as an SEC employee to obtain information about a pending investigation of the private equity firm while negotiating his new position. The firm itself is being investigated for sales practice violations. The defendant faces more than 20 years in prison.
This case is Exhibit A for why there should be limits on the revolving door between the regulators and firms they are charged with regulating. An inherent conflict of interest exists when a former regulator represents a firm being examined or investigated. The Project On Government Oversight (POGO) published a report in 2013 titled “Dangerous Liaisons: Revolving Door at SEC Creates Risk of Regulatory Capture,” outlining the scope of the problem. At the very least, we would recommend a 12-month cooling-off period before a private firm could hire a former regulator and an outright ban if the firm is currently under investigation.
FINRA has released its 2019 Report on Examination Findings and Observations, offering insight on enforcement cases and risk management concerns. FINRA provides a long list of examination and enforcement findings including negligent practices related to (i) supervision (failure to amend WSPs for new or amended rules, weak branch office inspections); (ii) suitability (product exchanges, churning); (iii) digital communications (failure to stop individual texting, electronic sales seminars); (iv) anti-money laundering (inadequate transaction monitoring, overreliance on clearing firms); (v) UTMA/UGMA (know your customer); (vi) cybersecurity; (vii) business continuity plans; (viii) fixed income mark-ups; (ix) best execution; (x) market access; (xi) short sales; (xii) liquidity risk management; (xiii) segregation of client assets; and (xiv) net capital. A senior FINRA official explained the purpose of the Report: “We hope firms find the Exam Findings and Observations Report useful in strengthening their own control environments and addressing potential deficiencies before their next exam.”
The Exam Report is more useful than the annual Exam Priorities letter because it reflects actual cases and findings rather than a regulatory wish list. We recommend that all compli-pros establish an internal working group to address the issues raised in the Report.
The SEC has proposed a new rule for the expedited review of exemptive applications under the Investment Company Act. Under the proposal, an applicant could request expedited review if the application is substantially identical to two other applications granted within the prior two years. If the staff agrees that expedited review is permitted, the staff will issue the notice within 45 days of filing. Additionally, the SEC has proposed a rule requiring that the staff take some action (e.g. providing comments) within 90 days of filing any exemptive application. The SEC acknowledges that lengthy reviews delay transactions, prevent firms from rapidly adapting to changing market conditions, and slow product development.
The entire industry should get behind this initiative. In fact, we would go further by requiring staff to document any objections and obtaining senior approval before kicking an applicant out of the expedited process. Regardless, let’s not make perfect the enemy of good. The SEC has acknowledged the problem with slow exemptive application reviews as far back as the early 1990s. It’s time to act.
In a recent FAQ, the staff of the SEC’s Division of Investment Management suggests that investment advisers consider rebating revenue sharing received from third parties against account-level fees. The FAQ purports to offer disclosure and mitigation guidance for advisers that receive payments or benefits from third parties for recommending certain classes of mutual funds. The staff requires extensive disclosure including the share classes available, differences in expenses and performance, limitations on the availability of share classes, conversion practices, how the adviser recommends different share classes, and the existence of incentives. The staff also encourages advisers to disclose “[w]hether the adviser has a practice of offsetting or rebating some or all of the additional costs to which a client is subject (such as 12b-1 fees and/or sales charges), the impact of such offsets or rebates, and whether that practice differs depending on the class of client, advice, or transaction” such as ERISA accounts.
We believe that, through these extensive disclosure requirements, the SEC staff is effectively outlawing revenue sharing unless the adviser rebates the compensation to clients. Disclosure alone may never be sufficient for an adviser to satisfy its fiduciary obligations. This standard would conform with how ERISA treats qualified accounts.
A federal court has ordered rescission, including $3.5 Million in disgorgement and $3.2 Million in penalties, with respect to an offering that falsely claimed to satisfy Regulation A. According to the SEC, the sponsors lied to the SEC by claiming a U.S.-based principal place of business when, in fact, the firm was run entirely outside of the U.S., and its sole U.S. contact was one employee in shared office space. The SEC also accuses the sponsor of lying to NASDAQ by inflating its float with non-qualifying insider transactions. A court previously ordered $26 Million in penalties for unlawful sales of insider securities that did not qualify under Rule 144.
Lying to the regulators in public filings to qualify for exemptions will lead to big trouble. Ordering rescission is the Big Kahuna of enforcement penalties because it involves returning all proceeds with interest in addition to fines and usually an ongoing cease and desist order. Act deliberately when filing that Form D or making those Rule 144 representations.
The SEC Division of Investment Management’s Disclosure Review and Accounting Office has warned the fund industry to improve its fee and performance disclosure. In its most recent release, the DRAO highlighted “several issues” including failures to verify the accuracy of performance and fee information. In particular, the DRAO cites multiple funds that have failed to reflect the effect of sales loads in their average annual returns table, showing negative performance as positive performance, and transposing the performance of different fund classes and benchmarks. The DRAO also faults fund-of-funds for failing to show the expenses of underlying acquired funds. Funds also routinely make arithmetic errors and fail to properly use XBRL tags. The DRAO “encourage[s] funds to closely review their performance and fee disclosures prior to providing them to investors.”
Over the years, many fund firms have delegated the preparation of registration statements to low-cost service providers that may not have the necessary knowledge, staffing and/or systems to prepare correct filings. When hiring a vendor (administrator, lawyer, auditor), make sure that the firm has the experience and the resources to do your job right. The cheapest is never the best and could cost you in the long run with a rescission or enforcement order.
The SEC fined an investment adviser and its two principals, including its dual-hatted Chief Compliance Officer, for failing to disclose the principals’ financial interest in a recommended investment. The two principals provided consulting services to a public company that they recommended to clients for investment. The principals received common stock in the company as compensation and also bought stock directly. The SEC alleges that neither the firm nor its principals disclosed their financial interests to clients who collectively owned 8.7% of the company. The SEC also accuses the principals with misleading an outside compliance consultant by failing to respond to requests for information about any business in which the principals had a financial interest.
This case shows the importance of hiring a full-time, independent Chief Compliance Officer who can dispassionately review firm and principal transactions and implement necessary procedures and disclosures. The dual-hat model, where a firm principal or executive officer half-heartedly owns compliance, does not work in today’s regulatory environment where the SEC and institutional clients demand an independent and experienced compliance officer
The SEC fined and censured a non-traded REIT sponsor for acting as an unregistered broker-dealer and using unlawful marketing tactics. The fund sponsor, bypassing the use of a registered broker-dealer, marketed the REITS on its website, through social media, and on the radio and collected 3% of the offering proceeds. The sponsor also used radio endorsement adds to market the REITs and subsidized an investor relations team to follow up with interested investors. The SEC asserts that the sponsor violated Section 15(a) of the Exchange Act by operating as a broker-dealer without registration. The SEC also charges the firm with using marketing materials that did not comply with the Securities Act’s prospectus requirements.
Rule 3a4-1 provides a very limited safe harbor that allows issuers to offer their own products without the involvement of a broker-dealer. To rely on the safe harbor, the issuer cannot receive commissions in connection with the sale of the investment product. This issuer probably could have used some timely legal and compliance advice before it launched a broad-based marketing campaign.