The SEC has once again proposed new derivatives rules for registered funds including mutual funds, ETFs, closed-end funds, and BDCs. Funds that employ derivatives would be required to limit leverage to 150% of the value-at-risk of a designated referenced index. The fund would also have to create a derivatives management program that would include a designated derivatives risk manager in addition to stress testing, backtesting, reporting and escalation procedures, and reviews. Different rules would apply to levered or inverse funds, although any adviser or broker-dealer recommending or selling such funds would have to implement due diligence procedures for retail accounts. A 60-day comment period will follow publication.
Here we go again. The SEC tried derivatives reform back in 2015 but never adopted the rule in the face of industry objections. The new proposal puts a lot of burden on the designated derivatives risk manager which, we expect, means more work for the Chief Compliance Officer.
The SEC has accused an alleged securities fraudster of conditioning returns of shareholder funds on agreements that prohibited the investors from communicating with the SEC. According to the SEC, certain suspicious investors received a refund of the money invested upon executing a Stock Purchase Agreement and/or Settlement Agreement that prohibited them from communicating with the SEC or any other governmental agency. The defendants also sued two of the investors for violating this provision, claiming that speaking with the SEC would jeopardize the entire enterprise including the current stock valuation. The whistleblower rules prohibit any actions to “impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement.”
OUR TAKE: Hire a lawyer that actually knows the law. It’s pretty clear that the confidentiality provisions violated the whistleblower rules. To attempt to enforce the illegal provisions through a lawsuit is doubling down on the malpractice.
The SEC reported near-record activity in its whistleblower program for 2019. The Office of the Whistleblower received more than 5,200 tips in fiscal in 2019, nearly equaling last year’s record total. However, only eight individuals received a portion of the $60 million in whistleblower awards in 2019. Since the program began in 2011, the SEC has received over 33,000 tips but has awarded a total of $387 million to 67 individuals. The most common tips involve corporate disclosures and financials, offering fraud, and manipulation. The SEC expects to adopt new rules that expand the program in 2020.
The SEC whistleblower program has made awards to only 0.2% of tips (67/33,300). While we laud the $2 Billion that has been recovered, we wonder whether the SEC could develop a more efficient reporting mechanism.
The dually-registered IA/BD affiliate of a large investment bank agreed to reimburse clients over $12 Million and agreed to pay a $1.5 Million fine because its advertised system failed to recommend the most economical fund share classes. The respondent marketed an automated mutual fund share class selection system that purported to pick the least expensive share classes for certain retirement plan and charitable organization customers. The SEC asserts that the system had programming and design flaws and that the respondent failed to adequately test and validate whether the system worked as advertised. Over the course of a 7-year period, the respondent overcharged over 18,000 clients.
Automated compliance systems are helpful, but they are not a cure-all. Like any tool, a compliance technology is only as good as the people using it. Bad inputs cause bad outputs. Also, firms can’t just “set it and forget it,” hoping that the system works.
The SEC’s Office of Compliance Inspections and Examinations (OCIE) has warned the registered fund industry about rampant regulatory violations involving compliance programs, disclosure, advisory contract approvals, and Codes of Ethics. In a recent Risk Alert detailing common deficiencies and weaknesses uncovered during 300 examinations over the last two years, OCIE chided the industry for weak compliance programs including policies and procedures that failed to prevent violations of investment guidelines or to ensure fulsome disclosure in fund marketing materials; breakdowns in providing the Board with adequate fair valuation information and broker quotes; weak service provider and subadviser oversight; and inadequate annual reviews. OCIE also criticized the information used to approve advisory contracts as well as shareholder disclosure in offering documents. OCIE also warned that funds need to enhance their Codes of Ethics including reporting and how to define “access persons.”
Hire better service providers. Not every lawyer knows the Investment Company Act Board approval, disclosure, and reporting rules. Not every compliance person understands Rule 38a-1 and how to implement fund procedures and testing. Not all administrator/distributors understand the differences between private funds and registered funds. You wouldn’t hire a neurologist to perform surgery. You shouldn’t hire just any lawyer or compliance consultant to implement your registered fund regulatory program.
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 this week, the SEC proposed a new investment adviser advertising rule that would dramatically alter current adviser marketing practices. Proposed Rule 206(4)-1 changes the definition of “advertising,” applies different standards to retail-directed advertisements, allows testimonials, and requires a responsible employee to review and approve all materials. The Release is over 500 pages, so we offer a summary of the most significant changes in the proposed rule. Please note, however, that this proposal still has to go through a lengthy comment process before the law actually changes.
The 10 Most Significant Changes in the Proposed Adviser Advertising Rule
- Expanded Definition of “Advertisement”. The proposed rule applies to “any communication, disseminated by any means.” This definition includes all digital and social media communications.
- Includes Private Funds. The definition of “advertisement” includes communications intended to obtain investors for a pooled investment vehicle (other than a registered fund) advised by the investment adviser.
- Gross Performance Allowed. The proposed rule allows the use of gross performance for non-retail accounts if the adviser includes the fees and expenses that would be deducted to determine net performance.
- Performance Periods. Retail advertisements (see below) must include one, five, and ten-year (or life if shorter) performance numbers.
- Extracted Performance Restricted. A presentation of a subset of portfolio performance must include (or offer to provide) the results of all portfolio investments.
- Higher Standards for Retail Advertisements. A retail advertisement is a communication directed to anybody other than a qualified purchaser (Investment Company Act Section 2(a)(51)) and a knowledgeable employee (Investment Company Act Rule 3c-5). For example, an adviser can only show gross performance if it also shows net performance.
- Practically Outlaws Hypothetical Performance. The disclosure requirements for the use of hypothetical performance are so stringent that the rule essentially outlaws the use of such information.
- Testimonials Permitted. For the first time, advisers could use client testimonials so long as significant disclosure is included. This will facilitate social media comments and likes.
- Designated Reviewer. A designated employee (presumably the Chief Compliance Officer) must review and approve all advertisements.
- Compliance and Recordkeeping. The new rule requires advisers to enhance policies and procedures to ensure the accuracy of any marketing claims, comply with the new Rule’s requirements, and maintain supporting documentation.
The SEC Enforcement Division ordered over $4.3 Billion in monetary penalties for the fiscal period that ended September 30, thereby setting a modern record, according to its 2019 annual report. Total penalties exceeded amounts ordered during each of the prior four years. The SEC also brought 826 total actions and 526 standalone actions, surpassing totals for 2015, 2017 and 2018 and nearly equaling the 868 cases filed in 2016. The most cases (191; 36% of total) were brought against investment advisers and investment companies. The Enforcement Division continues to prioritize charging individuals (69% of cases) and to pursue referrals to law enforcement (400 investigations). The SEC also imposed 595 bars and suspensions. The Co-Directors lauded the Division: “By any measure, we believe the Division had a very successful year.”
Regardless of administration, the SEC Enforcement Division continues to set new enforcement records. Nothing suggests any changes for the current fiscal year. If you haven’t received the memo, it’s time to get your compliance house in order.
The SEC has proposed a new investment adviser advertising rule that broadens the definition of “advertising,” more specifically regulates performance information, and allows certain testimonials and endorsements. Revised Rule 206(4)-1 would broadly include any communication distributed by any means that promotes advisory services or a pooled fund and prohibits any misleading or unsubstantiated statements. The new rule would also require all retail-directed advertisements to include one, five and ten-year periods when presenting performance information. Advisers would also be able to use testimonials so long as the adviser fully discloses whether the person is a client and whether compensation has been provided. The new rule would also require approval in writing by a designated employee before dissemination. The SEC said it may rescind current no-action letters. The SEC also proposed a new solicitation rule that would require additional disclosure about the solicitor but eliminate the current rule’s requirement to collect client acknowledgements. Both rules require at least a 60-day comment period.
We like that the SEC has modernized certain areas (e.g. testimonials) and has clarified how to present performance information. We believe that clearer rules help compliance professionals and reduce the likelihood of enforcement cases resulting from subjective standards.
The outside counsel to a firm charged with securities fraud was barred from practicing before the SEC and faces criminal charges for issuing fraudulent opinion letters. The SEC alleges that the lawyer knowingly omitted material facts in order to opine that his client’s note offering did not constitute a securities offering. The lawyer rendered the opinion letters even though two other law firms came to a different conclusion. The SEC further asserts that the lawyer rendered the fraudulent letters because he received commission on the sales of the notes. The SEC charges the lawyer with aiding and abetting securities fraud.
The SEC (and the U.S. Attorney) will take action against securities markets gatekeepers such as outside lawyers for aiding and abetting securities violations even though the defendant is not directly registered with the SEC. Serving as outside counsel does not allow a lawyer to further a client’s fraud.