We believe that the SEC should expand the “accredited investor” definition and allow broader use of private pooled funds for capital raising and investment. However, we have been here before in 2017, 2013, and 2010. Let’s hope Chairman Clayton, who focuses on capital raising, can make true reform happen this time.
The SEC fined a Big 4 audit firm $50 Million for misappropriating information from the PCAOB concerning impending inspections. Several members of firm management were also terminated and charged. The firm obtained the confidential exam information from employees that previously worked at the PCAOB as well as PCAOB employees being recruited by the firm. Information included lists of audit engagements that the PCAOB planned to inspect, specific criteria used for the inspection, and the focus areas. The SEC alleges that the firm also reviewed and revised work papers to avoid deficiencies. Separately, the firm was also charged with sharing answers and adjusting scores so that internal personnel could more readily pass internal continuing education courses. The SEC charges the firm with failing to comply with ethics and integrity standards, AICPA conduct rules, and PCAOB quality control standards. In addition to the fine, the firm agreed to retain an independent consultant.
The SEC relies on the securities markets gatekeepers, such as the large audit firms, to police the industry. When the gatekeepers act without integrity, it undermines the SEC’s ability to protect investors. This case once again raises the issue whether government officials should observe a cooling-off period before going to work for the companies they previously regulated.
Welcome to the June 2019 edition of the Best of the Law Firms. In this feature, we recommend some of the best recent articles and analyses authored by top investment management lawyers. These articles offer a more comprehensive review of the issues that we address in our daily “Our Take” alerts.
The law firms continue to offer up some great articles for the investment management industry. We have included several year-end litigation and trend reviews from Morgan Lewis, Stradley Ronon, and Willkie Farr. We also like the analyses of new products including interval funds (Ropes & Gray), opportunity zone funds (K&L Gates), cannabis (Kramer Levin), and litigation finance (Schulte Roth). There are some other great pieces of work about hedge fund seeding (Seward & Kissel) and DoL investigations (Groom).
The SEC charged a University of Georgia undergraduate with running a Ponzi scheme out of his fraternity house. The SEC asserts that he utilized group texts to solicit others associated with the university to invest in a hedge fund which did not exist. He also used on-line cash applications as a means for one investor to send money to other investors to further his scheme. The respondent touted high historical returns and false credentials. The SEC contends that the respondent used the funds for personal expenses including gambling junkets and adult entertainment.
Affinity-based Ponzi schemers will use their positions of trust to swindle funds from the naïve and unsuspecting. In this case, the tools may be new (group texts, cash apps, fraternity), but the con job is as old as the securities markets. Tell your friends and family not to give money to anybody without checking the SEC website and making sure the “manager” is registered.
Let’s rename this “The Compliance Officer Full Employment Act.” Compli-pros at broker-dealers will have to rework all of their Written Supervisory Procedures, revise client agreements, create disclosures, and eliminate all prohibited conflicts. Compliance offices at investment advisers must address the new Form CRS requirement and implement new client onboarding procedures while figuring out the changes required by the investment adviser fiduciary interpretation. And, we only have 12 months to get this all done.
The SEC fined a hedge fund $5 Million, and its Chief Investment Officer another $250,000, for failing to properly value portfolio securities. The SEC maintains that the firm over-relied on the discretion of traders to value Level 3 mortgage-backed securities rather than use required observable market inputs. The SEC contends that the firm consistently undervalued bonds to maximize profit upon sale. The SEC faults the CIO for failing to properly review valuation decisions and ensure that the traders followed the firm’s valuation procedures. The SEC asserts violations of the compliance rule (206(4)-7) because the firm failed to implement reasonable policies and procedures to ensure fair valuation of portfolio securities. As part of the settlement, the firm hired an experienced Chief Compliance Officer rather than rely on its prior Risk Committee comprised of executives with limited regulatory and valuation experience.
Valuation is about process. Firms that buy Level 3 securities must create a consistent, documented and contemporaneous process based on objective criteria in order to defend pricing decisions. For compli-pros, one way to test valuation is to sample whether liquidation prices vary consistently (either always higher or lower) than the firm’s internal valuations before liquidation.
The Chief Compliance Officer has extraordinary (and in some cases, unwarranted) access to employee records in addition to other confidential information such as executive meetings and emails. Firms should pursue enhanced background due diligence on potential CCO candidates, create information barriers so that the CCO does not have access to non-regulatory information, and implement a supervisory structure that ensures CCO accountability. Alternatively, consider outsourcing to a third-party firm that has limited access to firm systems as well as direct legal liability for breaches of confidentiality.
The use of social media to disseminate false information is a big social issue, but such conduct has significant economic and legal consequences in the securities markets. Perhaps, the regulators (led by the SEC’s Cyber-Unit) should engage with social media platforms to determine how to regulate the third-party distribution of information about specific issuers.
The SEC charged an investment adviser’s principal, who also served as the firm’s Chief Compliance Officer, with multiple compliance violations. The SEC charges the respondent with (i) overcharging his client, (ii) overstating his assets under management, (iii) failing to disclose two client lawsuits, (iv) misrepresenting the reason he switched custodians, and (v) neglecting to maintain required books and records. The SEC also alleges that the principal aided and abetted violations of the compliance rule (206(4)-7) by purchasing a template compliance manual, omitting required policies and procedures, and failing to implement required procedures. The firm ultimately ceased operations, and the respondent agreed to pay over $500,000 in fines, disgorgement and interest.
The dual hat CCO model (i.e. a senior executive also serving as the Chief Compliance Officer) doesn’t work. The dual-hat CCO usually does not have the time, expertise, or interest to do the job properly. Also, a CCO must have enough independence from the business to properly enforce the applicable regulatory and compliance obligations.