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The Friday List: 10 Ways Compliance Contributes to Firm Value

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.

Senior executives may view spending on compliance as a necessary evil or a cost of doing business.  While compliance spending is certainly necessary and a cost, the compliance function, properly structured and implemented, can significantly contribute to a firm’s value.  We believe the added value can actually exceed the cost, and compliance spending can be viewed more broadly as an investment in the business.  So, for today’s list, we offer 10 ways that compliance contributes to firm value.

 

10 Ways Compliance Contributes to Firm Value

 

  1. Avoid Fines and Penalties:  All firms want to avoid the punitive and unplanned fines, penalties, and disgorgement associated with enforcement actions that a good compliance program can prevent.
  2. Protect Individual Reputations:  The SEC names a corporate officer in over 80% of enforcement actions.  Your name in an enforcement action could be career-ending, especially if you are barred from the industry.
  3. Attract Institutional Clients: Most institutional investors conduct Operational Due Diligence that includes an in-depth review of the compliance program.  A weak compliance program can disqualify a firm regardless of investment performance history.
  4. Increase Firm Multiple: Potential acquirers will assess a firm’s compliance program as a factor in the multiple offered.  An inadequate compliance program means more risk, and more risk means a lower multiple.
  5. Improve Operations:  Very often, the compliance procedures serve as a starting point for operational and desk procedures.  Also, the discipline of drafting and implementing procedures will serve as an example for finance, portfolio management, and product development.
  6. Reduce Executive Time:  Fewer compliance problems and the associated decline in operational problems means less time spent by executives dealing with non-productive headaches.
  7. Lower Legal Expenses:  A good compliance function will reduce the number of questions requiring outside counsel.  Firms will incur significant legal expenses when confronted with an avoidable enforcement action.
  8. Preserve Reputation:  An enforcement action undermines a firm’s reputation, the most valuable asset of any investment management firm.  Blue chip firms like to do business with other blue chip firms that have a reputation for integrity.
  9. Attract Employees: A quality compliance program will create a credible firm attractive to quality employees.  A “cowboy culture” will repel the top-notch employees needed to grow into an institutional franchise.
  10. Freedom from Fear:  You wouldn’t drive a car without good brakes.  Just like good brakes, a good compliance program allows firm management to move fast and seek new opportunities without fear of an unknown regulatory breakdown.

Another Mutual Fund Firm Fined for Distribution-In-Guise

Another mutual fund manager was censured and penalized ($22.6 Million) for paying distribution and marketing fees mis-characterized as sub-TA fees, in violation of Section 12(b) and Rule 12b-1 of the Investment Company Act.  The SEC alleges that the fund sponsor, through the manager and distributor, used fund assets to pay for distribution but told intermediaries and the Board that such amounts were for sub-TA (shareholder) services and would be paid out of the manager’s revenue rather than fund assets.  Additionally, the SEC charges that, even if the amounts were paid for legitimate sub-TA services, such amounts exceeded the caps set by agreements with the funds.

OUR TAKE: Many in the fund industry were waiting for the regulatory shoe to drop after the SEC first announced the distribution-in-guise sweep two years ago.  This makes 2 cases in 2 days against large fund companies.  Compliance officers must do their own sweep to determine whether fund sponsors are properly compensating intermediaries.

https://www.sec.gov/litigation/admin/2017/ia-4696.pdf

Fund Company Fined $4.5 Million for Unlawful Distribution-in-Guise

A mutual fund manager agreed to pay a $4.5 Million fine and reimburse the funds another $1.25 Million for making unlawful distribution and sub-transfer agency payments to intermediaries.  The SEC maintains that the fund company claimed to make payments solely out of its revenues but, as a result of a technical misclassification, paid amounts directly out of fund assets in violation of Rule 12b-1.  The SEC also asserts that the respondent paid sub-TA fees in excess of Board-approved caps disclosed in the registration statement.  The SEC charges violations of the antifraud provisions of the Advisers Act and the Investment Company Act (Sections 206(2) and 34(b), respectively) and Section 12(b) and Rule 12b-1 of the Investment Company Act for making distribution payments without proper Board and shareholder approval and disclosure.

OUR TAKE: This the SEC’s second major case pursuant to its distribution-in-guise initiative (See Fund Sponsor to Pay $40 Million for Using Fund Assets to Pay for Distribution).  Fund firms must make sure that sub-TA payments do not include payments for any kind of distribution or marketing services.  Also, Boards must vet and approve all such plans that make use of fund assets.

https://www.sec.gov/litigation/admin/2017/ia-4695.pdf

BD to Pay $28 Million Despite FINRA Safe Harbor

A large broker-dealer agreed to pay over $28 Million in restitution, fines, interest, and disgorgement for failing to properly supervise two brokers that the SEC alleges made misrepresentations about prices and profits in connection with secondary market trading of non-agency RMBS occurring nearly 5 years ago.  The SEC asserts that the two brokers misled customers about purchase/sale prices and market activity and charged excessive markups.  The SEC faults the firm for failing to implement a system to monitor customer communications.  This compliance breakdown constituted a failure to supervise because “the failure to have compliance procedures directed at [an underlying securities law violation] can be evidence of a failure reasonably to supervise.”  Also, the SEC further faulted the firm for charging excessive markups even though such markups were within FINRA’s 5% safe harbor policy because “Regardless of the applicability of the five percent guidance, the FINRA was explicit in stating that ‘[a] broker-dealer may also be liable for excessive mark-ups under the anti-fraud provisions of the Securities Act and the [Exchange] Act.’”  The two brokers were also fined and suspended.

OUR TAKE: The SEC breaks new legal ground in two ways: (1) explicitly linking underlying securities law violations by registered representatives as a predicate to a failure to supervise charge and (2) charging a firm even though it complied with a stated FINRA safe harbor.   What does this mean?  The SEC continues to move to a strict liability standard such that any violation by an employee constitutes a failure to supervise.  Also, broker-dealers must be wary about relying on stated FINRA safe harbors.

 https://www.sec.gov/litigation/admin/2017/34-80560.pdf

BD Fined after Self-Reporting Net Capital Miscalculation

The SEC fined and censured a broker-dealer who misrepresented its net capital by failing to account for SBA loans taken with its parent company as co-borrowers.  The net capital miscalculation was discovered by a new auditor and reported by the firm in amended FOCUS filings.  The SEC cites violations of Rule 15c3-1 (net capital rule) for operating with a net capital deficiency.

OUR TAKE: This is the type of technical enforcement action that compliance officers dread: no client harm, technical violation, self-reported.  Yet, the SEC still brings an enforcement case that highlights a breakdown.  The SEC does not give credit for good intent, only for compliance programs that prevent any and all violations.

https://www.sec.gov/litigation/admin/2017/34-80557.pdf

Best of the Web – March 2017

 

“If we had no winter, the spring would not be so pleasant: if we did not sometimes taste of adversity, prosperity would not be so welcome.” (Anne Bradstreet)

 

Welcome to the March 2017 BOTW.  Spring has sprung for the regulatory experts, who have produced a flowering of content.  There is something for everybody: Dechert and Skadden go holistic and offer broad reviews, Drinker looks at CCO liability, and Seward & Kissel comments on the hedge fund industry.  Pepper takes on tax in a podcast, Stradley Ronon offers some cybersecurity advice, and Perkins Coie tackles fintech.  As my old law professor used to advise, “Keep reading.”

 

2016 Year in Review: Division of Investment Management Guidance Updates (Dechert)

Compliance and Legal Officer Guidelines To Prevent Non-Line Supervisory Liability (Drinker Biddle)

Common Deficiencies. Why? Because People Don’t Get It! (Focus One)

Key Takeaways: Recent Investment Management Litigation and Regulatory Developments (Skadden)

Seward & Kissel’s 2016 New Hedge Fund Study (Seward & Kissel)

The New Tax Landscape for Investment Management (podcast) (Pepper Hamilton)

Think Outside the Breach: Six Legal Issues to Consider After Responding to a Cybersecurity Incident (Stradley Ronon)

SEC Exam Priorities White Paper (Oyster)

As Fintech Platforms Grow Up, Investment Management Firms Face the ‘Problems of Tomorrow’ (Perkins Coie)

Questions & Answers on State and Local Variations on the SEC Pay-to-Play Rule (K&L Gates)

The Bumpy Road To Protection For Internal Whistleblowers (Vedder Price)

Hedge Fund Activists: The Debate on Unlocking Value (Schulte Roth & Zabel)

Resigning From a Board of Directors: Considerations for VC Fund Designees (Paul Hastings)

Share Class Rules (podcast) (Thompson Hine)

Understanding Liquidity Risk Mgmt Programs (Alaric)

DOJ’s Criminal Fraud Section Provides Valuable Guidance on the Evaluation of Corporate Compliance Programs (Winston & Strawn)

Employee Benefits in the Trump Administration (Groom)

ETF Sponsor Did Not Obtain Required Exemptive Relief

A large ETF adviser agreed to pay a $1.5 Million fine for operating a fund without obtaining the required exemptive relief.  According to the SEC, from 2010 to 2015, the adviser relied on exemptive relief for a separate ETF trust even though the SEC staff had opined that the relief did not apply to the fund at issue.  The SEC asserts that both internal and outside counsel advised (incorrectly, according to the SEC) that the firm could rely on the pre-existing exemptive relief.  The SEC did acknowledge that the fund complied with exemptive order requirements even though it did not obtain its own, specific relief.  The offending fund was merged out of existence in 2015.  An exemptive order is required to operate an ETF because it would otherwise violate various pricing provisions of the Investment Company Act.

OUR TAKE: Why would the SEC take action against a fund that no longer exists and an adviser that complied with conditions that would have been applicable to a fund where no investor harm was alleged?  The answer is that the SEC is very serious about compliance with exemptive orders and ensuring that ETF sponsors strictly follow the conditions (see e.g. SEC 2016 Exam Priorities Letter).  Just because you are driving safely doesn’t mean you can drive without a license.

https://www.sec.gov/litigation/admin/2017/ic-32613.pdf

SEC Accuses Risk Management Professional of Insider Trading

The SEC filed insider trading charges against an investment bank VP who worked in the risk management department and received material nonpublic information as part of his duties to provide technical information to support internal committees.  According to the SEC, the defendant learned inside information about a pending going-private transaction when he was copied on an email intended for the firm’s Debt Loan Committee and those that supported its functioning.  The SEC alleges that the risk management VP used undisclosed personal brokerage accounts in his name and his wife’s name to trade call options and stock in the target, thereby collecting over $40,000 in ill-gotten gains.  In addition to the SEC’s civil charges, the U.S. Attorney has filed a parallel criminal action.

OUR TAKE: It hurts all compli-pros when a risk management professional misuses his position and access to engage in unlawful activity.  Who can you trust?  Presumably nobody, which is why nobody should be exempt from oversight and testing.

https://www.sec.gov/litigation/complaints/2017/comp-pr2017-83.pdf

Portfolio Manager Charged in Matched Trade Scheme

The SEC has commenced enforcement proceedings against the portfolio manager of a registered fund for engaging in a matched trade scheme that allowed him to generate $1.95 Million in profits at the fund’s expense.  The SEC alleges that the portfolio manager matched call options bought/sold from his personal brokerage account against matching options bought/sold by the fund in less liquid securities with relatively wide NBBO spreads.  These trades benefitted his brokerage account when he immediately sold the call options to third parties at more favorable prices.  The SEC maintains that the portfolio manager failed to disclose his personal brokerage account to his employer (for review under the Code of Ethics) and failed to disclose his employer to his broker-dealer.  The SEC charges violations of Investment Company Act Section 17(j) and Rule 17j-1 (Code of Ethics) as well as securities fraud.  The U.S. Attorney has filed a parallel criminal action.

OUR TAKE: The SEC will hold individuals liable for securities law violations they cause especially where they intentionally seek to evade compliance efforts by lying to their employers.  It is unclear at this point whether his employer will also suffer an action for failing to detect his unlawful trading.

https://www.sec.gov/litigation/complaints/2017/comp-pr2017-82.pdf

SEC ALJ Rejects Attorney-Client Privilege in Reliance-on-Counsel Defense

An SEC Administrative Law Judge has ruled that once a respondent waives attorney-client privilege by raising reliance-on-counsel as an affirmative defense, the client also waives privilege with respect to successor counsel.  The respondent claimed as an affirmative defense that it relied on outside counsel’s advice on the interpretation of state law, the main issue in the SEC case, and subsequently filed a malpractice action.  The respondent then tried to assert privilege with respect to communications with successor counsel.  The ALJ rejected the assertion of privilege because the affirmative defense constituted an implied privilege waiver that extended to “all communications with counsel relating to the same subject matter, even communications with other counsel.”  To hold otherwise would allow the respondent to abuse the privilege by using it as a shield and a sword, depending on the circumstances.  The ALJ also ordered the respondents to show cause why the successor counsel should not be disqualified because of its inherent conflict of interest as a potential defendant in another malpractice case.

OUR TAKE: The SEC does not particularly like the attorney-client privilege (See e.g. “SEC’s Enforcement Director Warns Defense Lawyers about Tactics.”)  Respondents should know that the Enforcement Division and the ALJs will seek to pierce the privilege when possible, making the reliance-on-counsel defense very difficult.

https://www.sec.gov/alj/aljorders/2017/ap-4619.pdf