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.
The Chief Compliance Officer of a registered investment adviser was barred from the industry and faces criminal sentencing for wire fraud for his role in overbilling clients over $11 Million over a 10-year period. The CCO, a 5% owner of the firm and a protégé of the firm’s CEO/principal, implemented several of the billing practices directed by the firm’s principal and 90% owner. Overbilling practices included double billing clients, charging the wrong fee, charging a management fee instead of a performance fee, failing to prorate fees, and billing for services not performed. The CCO admitted that he knew there was a high probability that the CEO was defrauding clients, but the CCO deliberately avoided learning the truth.
There is no “just following orders” defense for employees of registered investment advisers. We can appreciate the conundrum when your boss and mentor engages in wrongdoing; but, failing to resign and call out the wrongdoing can lead to significant civil and criminal penalties.
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.