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SEC’s Blass Announces Plans to Modernize Adviser Marketing Rules

The 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. 

Fund Manager Rigged Auction Process in Client Cross-Trades

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. 

Firm’s Procedures Did Not Guide Management on How to Respond to Red Flags

A large 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. 

Share Class Disclosure Initiative Ensnares 79 Firms for $125 Million

The SEC announced 79 settled enforcement cases whereby investment advisers agreed to disgorge more than $125 Million in the aggregate for recommending higher-cost mutual fund share classes and receiving revenue sharing.   The cases arose from last year’s Share Class Disclosure Initiative launched, which encouraged firms to self-report to avoid penalties.  The SEC charges that the firms recommended mutual fund share classes that were more costly than other available classes so that the firms or their personnel could receive 12b-1 fees in their capacities as broker-dealers or registered representatives thereof.  Each charged firm “has also undertaken to review and correct all relevant disclosure documents concerning mutual fund share class selection and 12b-1 fees and to evaluate whether existing clients should be moved to an available lower-cost share class and move clients, as necessary.”

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. 

BD Fined $2 Million for Under-Resourcing Compliance Monitoring

FINRA 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.

OUR 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. 

SEC Alleges that RIA and Principal Ignored Compliance Obligations

The SEC has commenced enforcement proceedings against an adviser and its principal for disregarding its compliance obligations for over 10 years.  The SEC alleges that the firm did not even draft or adopt compliance procedures until an SEC examination commenced in 2015, 11 years after it initially registered.  The SEC also asserts that the principal named two individuals on Form ADV as Chief Compliance Officers even though neither person had responsibility for compliance, and one of the individuals did not even know that he was named as CCO.  The SEC also charges the firm with failing to conduct annual compliance reviews, comply with the custody rule, and maintain required books and records. 

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. 

Dual Registrant Over-Charged for Affiliated Brokerage

The acquiror 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. 

Investment Banker Used Wife’s Brokerage Account for Insider Trading Scheme

An investment banker agreed to pay over $360,000 (including disgorgement, a fine equal to his ill-gotten gains, and interest) for using his wife’s brokerage account to engage in insider trading.  As part of his settlement, the SEC dropped the charges against his wife, which it named as a relief defendant.  The SEC alleges that the defendant made trades through his wife’s brokerage account based on material non-public information learned while advising on acquisitions of two Chinese companies.  Although the alleged wrongdoing occurred outside the United States, the defendant was a United States citizen with a residence in California. 

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. 

Fund Boards Allowed to Continue Main Agreements without In-Person Meetings

The staff of the SEC’s Division of Investment Management will allow registered fund boards to meet telephonically, rather than in-person, to approve the continuation of advisory and distribution agreements.  The no-action letter allows Boards to meet by telephone or video conference (or by other simultaneous meeting venue) to continue a previously-approved agreement so long as the in-person meeting is impossible due to “unforeseen or emergency circumstances” (e.g. illness, death, weather, or other force majeure), the approval does not request material changes, and the Board ratifies the approval at the next in-person Board meeting.  Also, a Board could use a telephonic approval if the Board discusses and considers all material information concerning approval but delays a final vote until the directors receive additional information or a contingent event occurs.  The no-action relief also applies to approvals of auditor engagements and 12b-1 distribution plans. 

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. 

The Friday List: Common Problems with Hypothetical Backtested Performance


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

  1. Failure to disclose limitationsOne common allegation is that firms fail to fully disclose the limitations on HBP.  
  2. Insufficient backup dataThe SEC will seek to verify that you have maintained adequate backup data to support your HBP claims.
  3. Cherry-picking time periodsMany firms have violated the SEC marketing rules when they cherry-pick a specific time period that makes their HBP look better
  4. Misleading disclosuresHidden or confusing HBP disclosure will draw the SEC’s enforcement interest.  
  5. Retrospective model changesFirms can’t keep tinkering with their models to improve the HBP results.
  6. Using incorrect historical market inputsThe SEC can verify actual market data from past time periods, so make sure you use the correct numbers.  
  7. Applying different modelsThe SEC has raised red flags when HBP differs significantly from audited or live performance information applying the same models.
  8. Using the wrong model rulesFirms have gone astray by applying different model rules to the backtested data than they use to manage real accounts
  9. Investments didn’t existThe SEC will call out HBP that includes investments that were not available at the time.  
  10. Faulty algorithmCheck the algorithm used, because faulty programming can result in inflated performance numbers.