A fund sponsor agreed to pay over $32.5 Million in disgorgement and penalties because its tax planning strategy harmed the funds it managed. In 2005, the fund manager caused the underlying funds to convert to partnerships in order to benefit from certain deductions. However, the deductions required the unwinding of securities lending transactions that benefited the funds. The SEC asserts that the fund sponsor did not disclose this conflict of interest to the Board or the shareholders. The firm failed to resolve the internal dispute between the tax department and the securities lending group, until (10 years later) the securities lending group informed the Chief Compliance Officer, who prompted an internal investigation. The SEC also faults the firm for not reimbursing the funds for certain foreign taxes paid as a result of the conversion to a partnership. The SEC gave credit, which resulted in a lower fine, to the CCO and the firm for initiating the internal investigation and the self-reporting.
It’s never a good idea to keep Compliance in the dark about internal conflicts of interest. The Chief Compliance Officer is in the best position to protect the long-term interests of the firm and clients.
The regulators can impose significant fines and penalties for failures to implement required policies and procedures without alleging any underlying loss or harm to investors. The failure to implement required risk management and compliance policies can itself serve as the predicate for an enforcement action.
Very often, these Risk Alerts immediately precede a specialized sweep exam or a focus during regular exams. We would recommend that all advisers and compli-pros take a hard look at their principal and agency-cross transaction practices and policies.
The SEC has filed a lawsuit against a lawyer that operated an investment adviser that allegedly defrauded former NFL players and misled them about the credentials of one of the principals. The lawyer represented the players in class action concussion litigation against the NFL and then solicited them to invest in private funds that purportedly invested primarily in securities. However, the SEC asserts that the fund primarily served to advance settlement payments to other clients in the litigation. Also, the SEC charges that the respondents failed to disclose that the lawyer’s investment partner had a long regulatory and criminal history that included an industry bar and jail time. Disclosure documents described the partner as an adviser and consultant when in fact he managed the funds and shared profits with the lawyer. Item 9 of Form ADV requires disclosure of disciplinary information for any current employee, officer, partner, or “any person performing similar functions.”
The SEC views Item 9 disciplinary disclosures as critical to Form ADV because it provides potential clients with a window on an adviser’s reputation. A person with a regulatory history can’t avoid disclosure simply by becoming a “consultant” when the actual duties and financials show otherwise.
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 in the summer, the SEC adopted Regulation Best Interest and new Form CRS and issued interpretations of an adviser’s fiduciary responsibilities and the “solely incidental” exception to adviser registration for broker-dealers. All-in-all, the SEC published more than 1300 pages of regulatory information. The compliance date for Regulation BI and Form CRS is June 30, 2020. Many firms (including ours) have authored excellent pieces describing the new rules. However, as we do nearly every day, we will attempt to provide the most important changes for your regulatory consideration.
The 10 Most Important Changes Required by Regulation Best Interest and Its Companions
Best Interest. Instead of ensuring that a recommendation is merely suitable, broker-dealers must act in the best interest of retail customers when making a securities transaction recommendation or an investment strategy.
BD Disclosure. Broker-dealers must disclose (see Form CRS) material facts (e.g. fees/costs, services, conflicts, discipline) to retail customers at or before any recommendation is made.
Policies and Procedures. Broker-dealers must adopt and implement written policies and procedures that address conflicts of interest (including proprietary products, sales contests, and non-cash compensation) and ensure compliance with Regulation Best Interest, which would include training, reviews, and testing.
Form CRS. At or before entering into a relationship with a retail client, both investment advisers and broker-dealers must deliver new Form CRS (also filed with the SEC), which includes information about the firm’s regulatory status and obligations, fees/costs, and services.
Use of “advisor”. Broker-dealers will be restricted in their use of the term “advisor” or “adviser.”
Due Diligence. Advisers will have a need to conduct a greater amount of due diligence on retail clients (as compared to institutional clients).
Account Monitoring. An adviser must continually monitor a retail client’s investment profile and situation to ensure that advice continues in the best interest of the client.
Conflicts Disclosure. An adviser must include specific disclosure about applicable conflicts of interest and not merely describe conflicts as hypothetical or possible.
Investment Discretion. Absent limiting circumstances, a broker dealer with investment discretion must register as an investment adviser.
Monitoring Compensation. Receiving compensation to provide ongoing account monitoring would require investment adviser registration.