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Fund Sponsor Pays $32.5 Million for Internal Tax Planning that Harmed Funds

 

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.

Chief Compliance Officer Helps Firm Avoid Bigger Fine

 

The SEC fined a BDC sponsor for violating its exemptive order, but the firm received credit for self-remediation after the Chief Compliance Officer discovered the missteps and reported them to the Board.  According to the SEC, the firm engaged in several impermissible joint transactions while seeking an exemptive order to engage in the transactions.  Also, the firm engaged in transactions that specifically violated the Order because it did not disclose certain conflicts of interest.  The SEC lauds the firm’s Chief Compliance Officer who identified the conflicts issue and informed the firm’s Board of Directors.  The firm was fined $250,000, but the SEC specifically considered the remedial acts undertaken by the respondent.

Credit to the CCO for likely saving his firm from a much larger fine had the firm not taken action. 

SEC Wants Funds to Re-Work Principal Disclosure Risk in Summary Prospectuses

 

The SEC’s Division of Investment Management, through its Disclosure Review and Accounting Office, requests that mutual fund sponsors revamp the principal risk disclosure in the summary prospectuses.  The staff “strongly encourage[s]” funds to list principal risks in order of importance (rather than alphabetically) to better highlight risks that investors should consider.  Although the staff recognizes that this requires subjective judgment, the staff will not comment on a fund’s methodology.  The staff also recommends that funds tailor principal risk disclosure rather than utilize generic, standardized disclosure across funds, especially where different funds have differing investment objectives and policies.  The staff also reminds registrants to leave non-principal risks and other details to the Statement of Additional Information.

New registrants should expect the Disclosure staff to provide significant comments if they merely offer kitchen sink disclosure for principal risks.

Clearing Agency Fined $20 Million for Inadequate Policies and Procedures

 

The sole registered clearing agency for exchange listed option contracts agreed to pay $20 Million in fines to the SEC and the CFTC for failing to adopt and implement reasonable policies and procedures.  The regulators allege that the clearing agency, an SRO designated as a systemically important financial market utility under the Dodd-Frank Act, did not adopt or enforce reasonable policies and procedures related to margin, credit exposure, risk management, and information security.  Also, the firm failed to obtain required approval  for changes in core risk management policies.  In addition to the fines, the respondent agreed to retain an independent compliance auditor and implement a series of board and executive level risk management oversight mechanisms.

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.

Advisers Ignoring Principal and Agency-Cross Rules

 

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert describing failures by investment advisers to comply with regulatory requirements when engaging in principal and agency-cross transactions.  OCIE found that many advisers did not even recognize that they were engaging in principal (direct transaction with client) or agency cross (receiving compensation on behalf of third party) transactions.  For example, many advisers faltered by not recognizing that a significant ownership interest in a private fund made them principals.  Also, advisers with broker-dealer affiliates often ran afoul of the agency-cross rules.  The OCIE staff also criticized advisers for failing to observe the significant notice and transaction-by-transaction consent requirements.  In response to this Risk Alert, OCIE “encourages advisers to review their written policies and procedures and the implementation of those policies and procedures.”

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. 

New York State Expands Securities Enforcement Statute

 New York Governor Andrew Cuomo signed a law that reinstates the 6-year statute of limitations for the Martin Act, a statute that prohibits deceptive practices in securities transactions.  A recent court case, seemingly counter to prior precedent, had limited the statute to three years.  The New York State Attorney General Letitia James stressed the importance of the Martin Act because “the federal government continues to abdicate its role of protecting investors and consumers.”  Governor Cuomo explained that NYS is “enhancing one of the state’s most powerful tools to prosecute financial fraud so we can hold more bad actors accountable, protect investors and achieve a fairer New York for all.”

We would have preferred that the New York State Legislature re-write the Martin Act to make it less ambiguous and subject to prosecutorial discretion.  This wrangling over securities enforcement and statutes of limitations make it difficult on the industry to fully understand and follow a clear standard of care.

SEC Alleges that Lawyer/Adviser Swindled Concussed NFL Players

 

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. 

The Friday List: The 10 Most Important Changes Required by Regulation Best Interest and Its Companions

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

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. Use of “advisor”. Broker-dealers will be restricted in their use of the term “advisor” or “adviser.”
  6. Due Diligence. Advisers will have a need to conduct a greater amount of due diligence on retail clients (as compared to institutional clients).
  7. 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.
  8. Conflicts Disclosure. An adviser must include specific disclosure about applicable conflicts of interest and not merely describe conflicts as hypothetical or possible.
  9. Investment Discretion. Absent limiting circumstances, a broker dealer with investment discretion must register as an investment adviser.
  10. Monitoring Compensation. Receiving compensation to provide ongoing account monitoring would require investment adviser registration.

Adviser Ignored Compliance Consultant’s Supervision Recommendations

 

The SEC censured and fined an investment adviser for failing to supervise one of its employees who engaged in an unauthorized cherry-picking scheme.  Although the adviser had procedures requiring preclearance of personal trades, the SEC asserts that the firm failed to implement the preclearance procedures even after a third party consulting firm notified the firm of its failures to implement.  As part of the settlement, the adviser will deliver the order to each of the affected clients.

When you hire a compliance consultant, you should not ignore their recommendations.  The SEC will likely assert that you have displayed an unwillingness to implement a legitimate compliance program.