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One Junior Employee in Shared Office Space Does not Qualify for Reg A Offering

 

A federal court has ordered rescission, including $3.5 Million in disgorgement and $3.2 Million in penalties, with respect to an offering that falsely claimed to satisfy Regulation A.  According to the SEC, the sponsors lied to the SEC by claiming a U.S.-based principal place of business when, in fact, the firm was run entirely outside of the U.S., and its sole U.S. contact was one employee in shared office space.  The SEC also accuses the sponsor of lying to NASDAQ by inflating its float with non-qualifying insider transactions.  A court previously ordered $26 Million in penalties for unlawful sales of insider securities that did not qualify under Rule 144.

Lying to the regulators in public filings to qualify for exemptions will lead to big trouble.  Ordering rescission is the Big Kahuna of enforcement penalties because it involves returning all proceeds with interest in addition to fines and usually an ongoing cease and desist order.  Act deliberately when filing that Form D or making those Rule 144 representations.      

SEC Warns Fund Industry about Inaccurate Performance and Fee Disclosures

 

The SEC Division of Investment Management’s Disclosure Review and Accounting Office has warned the fund industry to improve its fee and performance disclosure.  In its most recent release, the DRAO highlighted “several issues” including failures to verify the accuracy of performance and fee information.  In particular, the DRAO cites multiple funds that have failed to reflect the effect of sales loads in their average annual returns table, showing negative performance as positive performance, and transposing the performance of different fund classes and benchmarks.  The DRAO also faults fund-of-funds for failing to show the expenses of underlying acquired funds.  Funds also routinely make arithmetic errors and fail to properly use XBRL tags.  The DRAO “encourage[s] funds to closely review their performance and fee disclosures prior to providing them to investors.”

Over the years, many fund firms have delegated the preparation of registration statements to low-cost service providers that may not have the necessary knowledge, staffing and/or systems to prepare correct filings.  When hiring a vendor (administrator, lawyer, auditor), make sure that the firm has the experience and the resources to do your job right.  The cheapest is never the best and could cost you in the long run with a rescission or enforcement order.

Dual-Hat CCO and Partner Failed to Disclose Financial Interests to Clients

 

The SEC fined an investment adviser and its two principals, including its dual-hatted Chief Compliance Officer, for failing to disclose the principals’ financial interest in a recommended investment.  The two principals provided consulting services to a public company that they recommended to clients for investment.  The principals received common stock in the company as compensation and also bought stock directly.  The SEC alleges that neither the firm nor its principals disclosed their financial interests to clients who collectively owned 8.7% of the company.  The SEC also accuses the principals with misleading an outside compliance consultant by failing to respond to requests for information about any business in which the principals had a financial interest.

This case shows the importance of hiring a full-time, independent Chief Compliance Officer who can dispassionately review firm and principal transactions and implement necessary procedures and disclosures. The dual-hat model, where a firm principal or executive officer half-heartedly owns compliance, does not work in today’s regulatory environment where the SEC and institutional clients demand an independent and experienced compliance officer

SEC Fines Adviser for Paying Solicitors without Full Disclosure

 

The SEC censured and fined an investment adviser for paying solicitors without complying with the solicitation rule (206(4)-3).  The adviser had networking relationships with over 300 banks whereby the adviser paid the banks a substantial portion of the advisory fees received from clients referred to the adviser.  The SEC asserts that the adviser did not comply with the solicitation rule, which requires separate disclosure about the solicitation relationship, the specific terms, and the compensation received.  The adviser erroneously relied on a 1991 no-action letter, which stated that a bank need not register as investment adviser.  The no-action letter did not hold that bank solicitors were exempt from the solicitation rule.

We had predicted that the SEC would bring cases alleging violations of the solicitation rule.  The rule is intended to fully disclose the potential conflict of interest when a trusted adviser refers the client to an adviser that has provided a financial incentive.   A solicitor need not be registered as an adviser under state or federal law to come within the rule. 

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.

SEC Proposes Changes to Public Company Disclosure Regime

 The SEC has proposed significant changes to the disclosure requirements for public companies, including how a registrant describes its business, its legal proceedings and risk factors.  When describing the business (Item 101), the proposal would move to a more principles-based disclosure regime focused on material information a registrant should disclose rather than a list of topics.  The new disclosures should also include a discussion of how the management of human resources affects the business.  The proposal also would require a narrative about the effect of government regulations on a company’s capital expenditures, earnings and competitive position.  There will be a 60-day comment period following publication.

It’s always good to focus disclosure on the material issues.  However, every SEC administration trumpets a goal of “improving disclosure.”  This effort may be like putting a coat of paint on a structurally defective house to prepare it for sale.  The issue for public companies is not how the lawyers should interpret Item 101, but the onerous compliance and regulatory obligations that may discourage private and non-U.S. companies from accessing the public markets. 

Tech Company Fined $5.1 Billion for Failing to Disclose Customer Data Violations

The SEC fined a large technology company $100 Million for misleading shareholders in public filings about breaches of its policies protecting user information.  The firm was also fined $5 Billion by the FTC.   According to the SEC, the firm knew in 2015 that a researcher had violated its policies by obtaining and transferring confidential user data to a third party research firm.  Regardless, the defendant’s public filings for the next two years presented the risk of misappropriated data as hypothetical even though the researcher had already transferred the data and admitted the scheme to the defendant.  The SEC charged the company with violating the securities laws by issuing several misleading public filings.

Last February the SEC issued cybersecurity guidance to public companies about their obligations to fully disclose cybersecurity risks and incidents.  If public companies didn’t take the SEC seriously then, we expect that the combined $5.1 Billion in fines will garner attention.  For asset managers and broker-dealers, in addition to implementing required customer data protections, they must also consider their disclosures in Form ADV and Form BD as well as any relevant offering documents. 

Federal Court Says that Outside Advice is Not a “Get-Out-of-Jail-Free Card”

The United States Court of Appeals for the D.C. Circuit upheld the SEC’s decision that an investment adviser failed to fully disclose mutual fund revenue sharing even if it sought and relied on the advice of outside compliance consultants. The Court found that the adviser acted negligently by failing to fully disclose the conflict of interest inherent by receiving shareholder servicing payments for investing in certain funds offered by its broker/custodian. Although the record was unclear about whether the adviser sought or relied on an outside compliance consultant’s advice, the Court decided that it didn’t matter because “any reliance on such advice was objectively unreasonable because [the adviser] knew of their fiduciary duty to fully and fairly disclose the potential conflict of interest.” The Court did, however, throw out the SEC’s claim that the adviser intentionally filed a misleading Form ADV, because the SEC failed to show that the adviser acted with the requisite intent to deceive.

As we have previously reported, this case argues in favor of seeking outside advice because it will help defend against the claim that you acted with intent, which would draw more punitive penalties. However, the Court here makes clear that relying on outside advice, even though you (should) know otherwise, will not exonerate you from claims that you acted negligently.

SEC Proposes Streamlining Financial Information for Fund Acquisitions

The SEC has proposed modernizing the financial information for acquisitions and dispositions, including the acquisitions of investment companies. Proposed changes to Regulation S-X and Form N-14 include eliminating certain pro forma financial statement requirements and changing the “significant subsidiary” test. The proposal also includes specific reporting rules for investment companies rather than relying on financial statement requirements generally applicable to the acquisition of operating companies.

Revising the investment company acquisition process should facilitate legitimate transactions while ensuring that shareholders receive relevant, rather than voluminous, financial information.

Hedge Fund Seeding Platform Over-Allocated Internal Expenses

The hedge fund seeding platform created by a large asset manager agreed to pay over $2.7 Million in disgorgement, interest and penalties for over-allocating internal expenses.  The respondent created private equity funds to invest in third party hedge fund managers.  The firm then created an internal group of employees tasked with helping hedge fund managers in which the funds invested to attract new capital, launch products and optimize operations.  Pursuant to their organizational documents, the funds would pay up to 50 basis points for these activities.  The SEC charges that the respondent allocated all the group’s compensation expenses to the funds even though they spent a portion of their time on activities that benefitted the fund sponsor and unrelated to the enumerated activities.   The SEC faults the firm for failing to implement appropriate compliance policies and procedures and for making material misstatements.

Do not charge expenses to managed funds unless the organizational and disclosure documents are absolutely clear that the funds will bear the expenses.  When doing internal expense allocations, always err to the side of benefitting the fund rather than the fund manager.