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Author: Todd Cipperman

FINRA Releases Exam Findings

 

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.

SEC Proposes Expedited Exemptive Reviews for Registered Funds

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.

SEC Staff Suggests that Advisers Should Rebate Revenue Sharing

 

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. 

One Junior Employee in Shared Office Space Does not Qualify for Reg A Offering

 

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.      

SEC Warns Fund Industry about Inaccurate Performance and Fee Disclosures

 

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.

Dual-Hat CCO and Partner Failed to Disclose Financial Interests to Clients

 

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

REIT Sponsor Tried to Circumvent Hiring a Broker-Dealer for Distribution

 

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.

Seventeen Additional Advisers Charged with Recommending Higher Cost Fund Share Classes

 

The SEC ordered the payment of over $125 Million in disgorgement and interest against 79 investment advisers who self-reported that they recommended share classes that paid back 12b-1 fees when lower-cost share classes were available.  Combined with the group of settlements back in March, the SEC has brought 95 total cases and ordered over $135 million returned to investors pursuant to its Share Class Selection Disclosure Initiative.  The largest restitution order of the most recent 16 cases exceeded $2.9 Million.  The SEC also settled an action against a firm that did not self-report, resulting in a $300,000 fine in addition to ordering over $900,000 in restitution.  The cases allege that the firms did not sufficiently disclose the conflict of interest arising by recommending a share class that paid back revenue sharing to the adviser, its affiliates, or their personnel.

It is unclear whether this group of cases is the beginning, middle, or end of the Share Class Selection Disclosure Initiative.  Regardless, firms are on notice that they must clean up their disclosures and reimburse investors if they have recommended higher expense share classes. 

Rich College Student Misleads Outside Investors with Faulty Valuations

 

The SEC charged a private fund manager and its principals with using a non-standard valuation model to value structured notes, thereby inflating fund performance and fees.  The main principal launched his firm out of his college dorm room initially to invest his family’s fortune but ultimately marketed his fund to third-party investors.  Rather than value the underlying structured note investments pursuant to “fair value” as required by ASC 820, the firm used a proprietary valuation model that deviated significantly from industry norms, thereby inflating returns and fees.  The SEC asserts that the respondents lied to investors, the auditor, and the SEC staff about its valuation practices.  The SEC cites multiple violations of the Securities Act, the Exchange Act and the Advisers Act.

Although ASC 820 leaves some discretion to management, the inputs cannot consistently juice valuations and returns and must have some market-based support.  The SEC could preempt these types of practices by publishing more specific valuation guidance as previously promised

SEC Fines Adviser for Paying Solicitors without Full Disclosure

 

The SEC censured and fined an investment adviser for paying solicitors without complying with the solicitation rule (206(4)-3).  The adviser had networking relationships with over 300 banks whereby the adviser paid the banks a substantial portion of the advisory fees received from clients referred to the adviser.  The SEC asserts that the adviser did not comply with the solicitation rule, which requires separate disclosure about the solicitation relationship, the specific terms, and the compensation received.  The adviser erroneously relied on a 1991 no-action letter, which stated that a bank need not register as investment adviser.  The no-action letter did not hold that bank solicitors were exempt from the solicitation rule.

We had predicted that the SEC would bring cases alleging violations of the solicitation rule.  The rule is intended to fully disclose the potential conflict of interest when a trusted adviser refers the client to an adviser that has provided a financial incentive.   A solicitor need not be registered as an adviser under state or federal law to come within the rule.