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.
As we approach the end of the year, we can reflect on what we learned at the panoply of investment management conferences we attended since June. CCS professionals attended most of the major industry conferences and compared notes. As we talked, we concluded that some of the same themes arose from the conferences’ agendas and speakers. We thought our clients and friends might benefit from our meta-observations.
10 Things We Learned During the Fall 2019 Investment Management Conferences
- Proxy Voting. Nobody is exactly sure how to supervise proxy voting firms.
- Cybersecurity. The authorities are warning about targeted cybersecurity attacks, not just generalized cyber threats.
- RIA Advertising. Everybody likes the new RIA advertising rule, but many are concerned about heightened enforcement.
- Expense Transparency. The Investment Management Division is focused on fee and expense transparency especially as advertised fund expenses approach zero.
- Portfolio Management. OCIE will investigate whether portfolio management practices deviate from disclosures made to clients and investors.
- Custody. Private fund firms still do not comply with the custody rule either because they fail to delivery financials on time or because they fail to engage a PCAOB firm.
- Form CRS. Everybody is trying to make Form CRS as marketing-friendly as possible while including all required information.
- AML. There is over-reliance on clearing firms to perform anti-money laundering surveillance.
- Technology. Technology firms are selling a variety of solutions to automate advisers’ back and middle offices.
- ETFs. Industry players expect a proliferation of active ETF products in the wake of the proposed rule.
The Chief Compliance Officer of a broker-dealer lost another appeal of FINRA discipline for failing to review emails. The firm’s Written Supervisory Procedures required daily email reviews, but the CCO only sporadically reviewed emails and completely ignored email reviews for three months. Although the WSPs stated that the CEO had email review responsibility, the CCO knew that the CEO was not conducting email reviews and that the job fell to the CCO. The SEC rejected the CCO’s attempts to blame the third party email service. The same CCO lost a similar appeal last year with respect to his prior employer. The SEC notes that the firm and the CEO had responsibilities, but those obligations did not exculpate the CCO.
CCOs must proceed with caution with WSPs and work expectations to avoid assuming responsibilities that s/he will not or cannot undertake. You may think you’re helping out or just being a good team player when, in fact, you are assuming significant regulatory liability. No good deed goes unpunished when the work doesn’t get done.
The staffs of two SEC divisions published Form CRS FAQs that apprised advisers and broker-dealers that they can only use one Form CRS even if the firm offers multiple products and services. The newly adopted Customer Relationship Summary or Form CRS will require RIAs and BDs to provide retail customers with a description of the relationship including fees, services, standard of conduct, and firm information. The FAQs declare that a firm cannot deliver a separate CRS for each service but must prepare a comprehensive Form including all services. However, a dual registrant can prepare a separate Form CRS for its advisory and broker-dealer services. The FAQs also clarify that private fund sponsors need not deliver a Form CRS to retail investors in the funds. Also notable is that delivery of the Form CRS can be included with other document delivery so long as the Form CRS is “the first among any documents delivered…at that time” or are “presented prominently in the electronic medium.” The Divisions of Investment Management and Trading and Markets jointly issued the FAQs.
Time to start drafting. Call your lawyers and compli-pros to craft the Form CRS before the experts fill up their dance cards. After all, there are approximately 13,000 registered investment advisers and over 3,000 broker-dealers out there, most of whom have to prepare a Form CRS.
The U.S. District Court for the Northern District of Illinois ordered an investment adviser to pay over $1.8 Million in disgorgement and penalties for multiple violations of the Investment Advisers Act. The SEC asserts the adviser ignored the Advisers Act’s custody, recordkeeping, valuation, and disclosure rules while commingling assets and engaging in insider transactions. When confronted with the deficiencies following an SEC exam, the firm’s principal said that he was unaware of the existence of the Investment Advisers Act or the duties it imposed upon the firm and its principals. The founder’s son who served as Chief Compliance Officer was barred from the industry earlier this year.
Ignorance of the law is no excuse, and naivete will not insulate a Chief Compliance Officer from liability. When operating in a regulated industry, failure to retain competent regulatory advisers will result in a date with a federal judge.
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.