Home » Compliance Blog » Page 2

Exempt Reporting Adviser Barred and Fined Over $1.1 Million

The principal of an exempt reporting adviser was barred from the industry and agreed to pay over $1.1 Million in disgorgement and penalties for conflicted transactions and misrepresentations.  The SEC charges that the respondent caused a fund he managed to purchase a portfolio company from an affiliated fund in violation of the purchasing fund’s debt and concentration limits.  The SEC asserts that the respondent intentionally misled investors by undervaluing the portfolio company in financial statements and disclosure documents.  The SEC also claims that the respondent misled investors about underlying investments and charging undisclosed monitoring fees.  The SEC also fined the firm’s CFO/CCO.  The SEC cites violations of the anti-fraud rules under the Advisers Act (206(4)-8), the Securities Act (17(a)(1) and 17(a)(3)), and the Exchange Act (10b-5).

An exempt reporting adviser is still subject to several provisions of the Advisers Act, including its fiduciary and anti-fraud rules.  We recommend that ERAs implement a legitimate compliance program to avoid a firm-ending regulatory action like this one.

Private Fund Manager Completely Shirked His Compliance Obligations

 

The SEC fined a now-defunct fund manager for ignoring its compliance obligations.  The SEC charges that the firm never delivered audited fund financials within 120 days as required by the custody rule (206(4)-2).  Although the firm did hire an auditor, the firm never received an opinion that the financials were prepared in accordance with GAAP.  Instead, the audit firm issued reports stating that it was unable to express such an opinion.  In addition, the SEC charges the firm with violating the compliance rule (206(4)-7) because the principal, who also served as the Chief Compliance Officer, failed to adopt and implement policies and procedures and disregarded his obligation to conduct annual compliance reviews.

When you register as an investment adviser, you subject yourself to the full panoply of substantive regulation imposed by the Investment Advisers Act.  To comply and continue as a going concern, you need to hire a competent Chief Compliance Officer to help you meet the regulatory requirements.  Otherwise, you may end up either in your next career or in jail.

Dual Registrant Failed to Convert Inactive Fee-Based Accounts to Brokerage

 

A large dual registrant agreed to pay over $15 Million in fines, disgorgement and penalties for failing to convert inactive fee-based advisory accounts into traditional brokerage accounts.  The firm had policies requiring its financial advisers to conduct ongoing suitability reviews and flag those accounts without significant trading activity during the prior 12 months.  According to the SEC, the FAs, without an imposed deadline, failed to respond to requests from the Compliance Department to complete the reviews.  As a result, over a 5-year period, the firm failed to properly review nearly 8,000 accounts.  Once the SEC began an investigation, the firm converted 1700 accounts to brokerage and closed an additional 2000 accounts.  The SEC faults the firm for failing to have specific escalation procedures when they failed to respond to compliance inquiries and for neglecting to impose deadlines.  The SEC also charged the firm with unsuitable UIT recommendations.

Dual registrants (and parent companies of dual registrants) have this unique suitability compliance obligation that overrides the specific compliance programs for the investment adviser and its broker-dealer affiliate. The firm must determine which product line – fee-based account or traditional brokerage – is suitable and then continuously monitor the accounts to avoid either churning or, as in this case, reverse churning (i.e. inactive fee-based accounts).   Many industry observers used to think that fee-based accounts would displace bad brokers who churned accounts.  We have now come full circle as the regulator targets reverse churning.

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.