SEC’s Investment Management Division Director, Dalia Blass, anticipates that
the Division will soon recommend changes to the adviser marketing and solicitation
rules. In her annual speech to the Investment
Company Institute membership, Ms. Blass also announced initiatives for a
summary shareholder report, updates to the valuation guidance, modernization of
the offering rules for business development companies and closed-end funds, and
changes to the rules for funds’ use of derivatives. Additionally, Ms. Blass wants the Division to
finalize the proposed ETF and fund-of-funds rules. She has also asked the staff to begin an
outreach to small and mid-sized fund sponsors about regulatory barriers. She announced that the Division is
considering the formation of an asset management advisory committee to solicit diverse
viewpoints on critical issues.
We applaud the reinvigorated Investment Management Division for tackling some of the thornier problems that have faced the industry for many years. For instance, the marketing rules haven’t changed for decades despite revolutionary change in the financial services industry.
A private fund and CDO manager agreed to pay over $400,000 to settle charges that it facilitated an illegal cross-trade that benefitted one client over another. The SEC alleges that the firm sold securities held by its CDO client to its private fund at an artificially low price because the respondent failed to obtain required third-party bids. Instead, the SEC asserts, based on a record of a phone conversation, that the firm asked friendly firms to provide false bids with assurances that they would not have to purchase the securities. The private fund ultimately sold the securities at a significant profit. The SEC also charged the firm’s Chief Operating Officer (who was fined and barred from the industry) for arranging the transactions and personally benefitting through his investment in the private fund.
Firms should avoid client cross-trades. One side will always benefit, which gives rise to conflict of interest and favoritism allegations. A fiduciary on both sides of a transaction may not be able to cure the conflict with any amount of disclosure.
broker-dealer was fined and censured for failing to act against a longtime broker
charged with participating in pump-and-dump transactions. The SEC faults the firm for ignoring red flags
including emails outlining the illegal activity, FINRA arbitrations, and
customer complaints. One supervisor
explained that he did not act more aggressively because the broker worked at
the firm for 30 years and her business partner was a partial owner of the firm.
The SEC asserts that the firm’s supervisory system “lacked any reasonable
coherent structure to provide guidance to supervisors and other staff for
investigating possible facilitation of market manipulation.” The SEC also maintains that the firm “lacked
reasonable procedures regarding the investigation and handling of red flags.”
Reasonable policies and procedures must do more than simply restate the law and the firm’s commitment to comply with the law. The compliance manual or WSPs must specifically describe HOW a firm will prevent and address regulatory misconduct.
Firms that take revenue sharing from fund companies should consult counsel about their self-reporting options. Also, whether or not your firm self-reports, you should undertake the review of all relevant disclosure that the SEC has mandated.
fined a large broker-dealer $2 Million for under-resourcing its compliance
function, thereby allowing unlawful short-selling. As the firm’s trading activity increased, the
firm continued to rely on a primarily manual system to monitor compliance with
Regulation SHO’s requirements. The
handful of employees tasked with monitoring trading requested more resources as
their 12-hour workdays could not adequately surveil the activity of 700 registered
representatives. FINRA alleges that the
firm routinely violated Regulation SHO by failing to timely close-out
positions, illegally routing orders, and failing to issue required
notices. As part of the settlement, the broker-dealer
also agreed to hire an independent compliance consultant.
TAKE: Firms need to track business activity to ensure that compliance and operations
infrastructure keep up with the business.
A good metric is whether the firm spends at least 5% of revenues on compliance
infrastructure including people and technology.
The SEC will offer no quarter to RIAs who ignore their basic compliance responsibilities. At a bare minimum, firms must appoint a dedicated and qualified CCO, adopt tailored policies and procedures, annually test the program, and generally attempt to comply with the Advisers Act. The initiation of proceedings, rather than a settled order, suggests that the SEC intends to pursue aggressive penalties.
of a formerly dually registered RIA/BD agreed to pay over $5.7 Million because
the RIA/BD over-charged its clients for brokerage services. The SEC maintains that the RIA/BD encouraged
clients to select its affiliated brokerage program for trades because of
enhanced services and pricing. However,
the SEC alleges, the RIA/BD did not provide any services that clients did not receive
when selecting lower-cost brokerage alternatives, and brokerage costs were
higher. Although the firm disclosed that
the affiliated broker option resulted in the RIA/BD receiving more
compensation, the SEC faults the firm for failing to fully disclose that the
clients would have benefited from choosing a different brokerage option. The conflict of interest violated the antifraud
provisions of the Advisers Act.
Dual registrants that reach for revenue other than the stated asset management fee will draw the attention of the SEC Enforcement Division. The SEC has attacked dual registrants for revenue sharing, commission splitting, and brokerage practices. Also, firms looking to do acquisitions should understand that they can’t escape the acquired firm’s previous regulatory lapses.
This is why the definition of beneficial ownership for Code of Ethics reporting includes members of the immediate family sharing the same household. Also, we question the wisdom of implicating your unknowing spouse in an insider trading scheme.
The in-person meeting requirement is so archaic that it feels like it was adopted in 1940, although it was actually adopted in 1970. As a statutory requirement, the SEC cannot completely strike the in-person requirement without an act of Congress (which is not a bad idea). The SEC deserves some credit for adapting the rules to modern realities, and we would urge them to further liberalize the rules to the extent legally permissible.
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.
Every year, the SEC publishes a handful of enforcement cases
alleging that an investment adviser violated the advertising and marketing
rules by misusing hypothetical backtested performance (HBP). In our experience with exams, the SEC nearly
always cites deficiencies when firms use HBP in marketing. Although there is no rule specifically
prohibiting the use of HBP, our position is that firms should never use
HBP. To support our view, we have
highlighted below 10 of the most common HBP failings and cite to specific SEC actions
(click on links). As a side note, most institutional
investors with whom we work look very critically at HBP because they also
understand the limitations.
10 Common Problems with Hypothetical Backtested Performance