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 this week, the SEC proposed a new investment adviser advertising rule that would dramatically alter current adviser marketing practices. Proposed Rule 206(4)-1 changes the definition of “advertising,” applies different standards to retail-directed advertisements, allows testimonials, and requires a responsible employee to review and approve all materials. The Release is over 500 pages, so we offer a summary of the most significant changes in the proposed rule. Please note, however, that this proposal still has to go through a lengthy comment process before the law actually changes.
The 10 Most Significant Changes in the Proposed Adviser Advertising Rule
- Expanded Definition of “Advertisement”. The proposed rule applies to “any communication, disseminated by any means.” This definition includes all digital and social media communications.
- Includes Private Funds. The definition of “advertisement” includes communications intended to obtain investors for a pooled investment vehicle (other than a registered fund) advised by the investment adviser.
- Gross Performance Allowed. The proposed rule allows the use of gross performance for non-retail accounts if the adviser includes the fees and expenses that would be deducted to determine net performance.
- Performance Periods. Retail advertisements (see below) must include one, five, and ten-year (or life if shorter) performance numbers.
- Extracted Performance Restricted. A presentation of a subset of portfolio performance must include (or offer to provide) the results of all portfolio investments.
- Higher Standards for Retail Advertisements. A retail advertisement is a communication directed to anybody other than a qualified purchaser (Investment Company Act Section 2(a)(51)) and a knowledgeable employee (Investment Company Act Rule 3c-5). For example, an adviser can only show gross performance if it also shows net performance.
- Practically Outlaws Hypothetical Performance. The disclosure requirements for the use of hypothetical performance are so stringent that the rule essentially outlaws the use of such information.
- Testimonials Permitted. For the first time, advisers could use client testimonials so long as significant disclosure is included. This will facilitate social media comments and likes.
- Designated Reviewer. A designated employee (presumably the Chief Compliance Officer) must review and approve all advertisements.
- Compliance and Recordkeeping. The new rule requires advisers to enhance policies and procedures to ensure the accuracy of any marketing claims, comply with the new Rule’s requirements, and maintain supporting documentation.
The SEC Enforcement Division ordered over $4.3 Billion in monetary penalties for the fiscal period that ended September 30, thereby setting a modern record, according to its 2019 annual report. Total penalties exceeded amounts ordered during each of the prior four years. The SEC also brought 826 total actions and 526 standalone actions, surpassing totals for 2015, 2017 and 2018 and nearly equaling the 868 cases filed in 2016. The most cases (191; 36% of total) were brought against investment advisers and investment companies. The Enforcement Division continues to prioritize charging individuals (69% of cases) and to pursue referrals to law enforcement (400 investigations). The SEC also imposed 595 bars and suspensions. The Co-Directors lauded the Division: “By any measure, we believe the Division had a very successful year.”
Regardless of administration, the SEC Enforcement Division continues to set new enforcement records. Nothing suggests any changes for the current fiscal year. If you haven’t received the memo, it’s time to get your compliance house in order.
The SEC has proposed a new investment adviser advertising rule that broadens the definition of “advertising,” more specifically regulates performance information, and allows certain testimonials and endorsements. Revised Rule 206(4)-1 would broadly include any communication distributed by any means that promotes advisory services or a pooled fund and prohibits any misleading or unsubstantiated statements. The new rule would also require all retail-directed advertisements to include one, five and ten-year periods when presenting performance information. Advisers would also be able to use testimonials so long as the adviser fully discloses whether the person is a client and whether compensation has been provided. The new rule would also require approval in writing by a designated employee before dissemination. The SEC said it may rescind current no-action letters. The SEC also proposed a new solicitation rule that would require additional disclosure about the solicitor but eliminate the current rule’s requirement to collect client acknowledgements. Both rules require at least a 60-day comment period.
We like that the SEC has modernized certain areas (e.g. testimonials) and has clarified how to present performance information. We believe that clearer rules help compliance professionals and reduce the likelihood of enforcement cases resulting from subjective standards.
The outside counsel to a firm charged with securities fraud was barred from practicing before the SEC and faces criminal charges for issuing fraudulent opinion letters. The SEC alleges that the lawyer knowingly omitted material facts in order to opine that his client’s note offering did not constitute a securities offering. The lawyer rendered the opinion letters even though two other law firms came to a different conclusion. The SEC further asserts that the lawyer rendered the fraudulent letters because he received commission on the sales of the notes. The SEC charges the lawyer with aiding and abetting securities fraud.
The SEC (and the U.S. Attorney) will take action against securities markets gatekeepers such as outside lawyers for aiding and abetting securities violations even though the defendant is not directly registered with the SEC. Serving as outside counsel does not allow a lawyer to further a client’s fraud.
The Chief Compliance Officer of a registered investment adviser was barred from the industry and faces criminal sentencing for wire fraud for his role in overbilling clients over $11 Million over a 10-year period. The CCO, a 5% owner of the firm and a protégé of the firm’s CEO/principal, implemented several of the billing practices directed by the firm’s principal and 90% owner. Overbilling practices included double billing clients, charging the wrong fee, charging a management fee instead of a performance fee, failing to prorate fees, and billing for services not performed. The CCO admitted that he knew there was a high probability that the CEO was defrauding clients, but the CCO deliberately avoided learning the truth.
There is no “just following orders” defense for employees of registered investment advisers. We can appreciate the conundrum when your boss and mentor engages in wrongdoing; but, failing to resign and call out the wrongdoing can lead to significant civil and criminal penalties.
The SEC’s Division of Trading and Markets has provided limited period no-action relief to beta test a service that will allow securities clearance using a distributed ledger system. The 24-month relief would allow the applicant to operate a securities settlement service whereby securities and cash would be represented by digitized securities entitlements that would be exchanged in accordance with the underlying securities transactions. Without no-action relief, the applicant would have to register as a clearing agency. The SEC is allowing limited testing of the system without registration so long as the applicant follows strict guidelines that limit use of the system and volume.
The use of distributed ledger technology and digital tokens could revolutionize securities settlement and transfer agency processes. Securities settlement could happen more quickly with fewer transaction costs. The SEC (and the applicant) deserve credit for allowing this testing period before requiring full-blown registration.
The SEC instituted proceedings against a private fund manager and its principals for inflating the valuation of illiquid assets and conflicts of interest. The SEC charges that the defendants marketed a fund with the term “income” in its name even though the fund held only illiquid assets including a private company and interests in gems and minerals. The SEC also asserts that the defendants inflated the values of the fund’s assets in order to pay their management fees while telling investors that the fund lacked liquidity to meet redemption requests. The SEC claims that the defendants illegally paid themselves more than $13 Million in management fees. The SEC also asserts that the principals engaged in self-dealing insider loan transactions and invested client money in their affiliated funds.
Fund sponsors claiming limited liquidity or redemption gates make want to re-consider how and when to pay management fees especially based on assets that are not publicly traded. Also, private fund sponsors should review fund names and offering documents to make sure they remain accurate over time.
The U.S. Attorney for the Eastern District of New York has indicted the former Chief Compliance Officer of a private equity firm for obstructing justice and illegally accessing confidential government information. According to the indictment and press accounts, the defendant misused his position and access as an SEC employee to obtain information about a pending investigation of the private equity firm while negotiating his new position. The firm itself is being investigated for sales practice violations. The defendant faces more than 20 years in prison.
This case is Exhibit A for why there should be limits on the revolving door between the regulators and firms they are charged with regulating. An inherent conflict of interest exists when a former regulator represents a firm being examined or investigated. The Project On Government Oversight (POGO) published a report in 2013 titled “Dangerous Liaisons: Revolving Door at SEC Creates Risk of Regulatory Capture,” outlining the scope of the problem. At the very least, we would recommend a 12-month cooling-off period before a private firm could hire a former regulator and an outright ban if the firm is currently under investigation.
FINRA has released its 2019 Report on Examination Findings and Observations, offering insight on enforcement cases and risk management concerns. FINRA provides a long list of examination and enforcement findings including negligent practices related to (i) supervision (failure to amend WSPs for new or amended rules, weak branch office inspections); (ii) suitability (product exchanges, churning); (iii) digital communications (failure to stop individual texting, electronic sales seminars); (iv) anti-money laundering (inadequate transaction monitoring, overreliance on clearing firms); (v) UTMA/UGMA (know your customer); (vi) cybersecurity; (vii) business continuity plans; (viii) fixed income mark-ups; (ix) best execution; (x) market access; (xi) short sales; (xii) liquidity risk management; (xiii) segregation of client assets; and (xiv) net capital. A senior FINRA official explained the purpose of the Report: “We hope firms find the Exam Findings and Observations Report useful in strengthening their own control environments and addressing potential deficiencies before their next exam.”
The Exam Report is more useful than the annual Exam Priorities letter because it reflects actual cases and findings rather than a regulatory wish list. We recommend that all compli-pros establish an internal working group to address the issues raised in the Report.
The SEC has proposed a new rule for the expedited review of exemptive applications under the Investment Company Act. Under the proposal, an applicant could request expedited review if the application is substantially identical to two other applications granted within the prior two years. If the staff agrees that expedited review is permitted, the staff will issue the notice within 45 days of filing. Additionally, the SEC has proposed a rule requiring that the staff take some action (e.g. providing comments) within 90 days of filing any exemptive application. The SEC acknowledges that lengthy reviews delay transactions, prevent firms from rapidly adapting to changing market conditions, and slow product development.
The entire industry should get behind this initiative. In fact, we would go further by requiring staff to document any objections and obtaining senior approval before kicking an applicant out of the expedited process. Regardless, let’s not make perfect the enemy of good. The SEC has acknowledged the problem with slow exemptive application reviews as far back as the early 1990s. It’s time to act.