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.
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.
An investment adviser platform was fined and censured for receiving fund revenue sharing from a custodian and clearing firms it recommended without proper disclosure. The platform had more than 150 independent investment adviser representatives and 200 registered representatives working out of more than 100 offices. The SEC criticizes weak disclosure that failed to fully describe the conflict of interest when the firm recommended a custodian that kicked back 2 basis points on assets. The SEC also maintains that the firm violated disclosure, fiduciary and best execution obligations when it recommended mutual fund share classes that paid back 12b-1 fees to the firm and its reps when lower fee share classes were available. The firm did not meet its obligations with vague website disclosure that described how the firm “may” receive compensation but failed to fully inform all clients about how fees were paid or calculated.
OUR TAKE: The RIA platform business is extremely competitive, with many firms competing to recruit successful RIA teams. The real cost of an enforcement action like this is the reputational and competitive threat during the recruiting process. Also, as platforms compete for business and margins shrink, the incentives to accept (questionable) revenue sharing increases.
OUR TAKE: This case reads like a cautionary tale for large firms trying to quickly roll out a product. It appears that the portfolio management, marketing, legal, operations, and legal functions worked in silos, and, as a result, failed to properly vet or describe the products. We recommend that firms create a cross-functional product assessment team that can ask the hard questions before launching a product.
OUR TAKE: When it comes to cybersecurity incidents, time is not on your side. Because of the potential harm to clients and investors, it is better to provide immediate disclosure that will be followed up with additional information rather than waiting and thereby compounding the potential harm. Hacked firms must move quickly to investigate, assess, and remediate the harm to minimize damages.
A large mutual fund manager agreed to pay $3.6 Million in disgorgement, interest, and penalties for failing to disclose that affiliates would receive tax deductions that would deprive fund investors of securities lending income. The fund manager told investors and the Board that it would engage in discretionary securities lending and told the Board that affiliates could benefit from certain tax deductions. The SEC faults the respondent for failing to tell either investors or the Board that it might recall securities before the dividend record date, which allowed affiliates to take a dividend received deduction and deprived the fund and its shareholders of additional securities lending revenue. The SEC cites violations of the Advisers Act’s antifraud rules, acknowledging that proof of intent is not required and that such charges “may rest on a finding of simple negligence.”
OUR TAKE: This type of fraud charge based on simple negligence looks a lot like the type of “broken windows” enforcement cases that former SEC Chairman Mary Jo White championed. The SEC does not allege that fund investors would have made a different investment decision if it included the SEC’s enhanced disclosure. The conflict of interest makes the disclosure insufficient notwithstanding any effect on investors.
The SEC has issued cybersecurity guidance that directs public companies to adopt effective disclosure controls and procedures and overhaul their disclosure about incidents and threats. The SEC believes that public companies should adopt and implement cybersecurity risk management policies and procedures that ensure timely disclosure, internal reporting, processing of risks and incidents, and prevention of insider trading. The SEC also admonishes public companies to review all public disclosures including the materiality of incidents and security, risk factors, MD&A disclosure, business description, legal proceedings, financial statements, and board risk oversight. Firms should also consider disclosing past incidents “in order to place discussions of these risks in the appropriate context.” The SEC believes that “the importance of data management and technology to business is analogous to the importance of electricity and other forms of power in the past century.” The SEC said that it will be reviewing cybersecurity disclosures.
OUR TAKE: We expect institutional investors will add similar cybersecurity inquiries into their Operational Due Diligence processes before choosing an investment firm. So, even if you do not work for a public company, you should consider implementing the SEC’s recommendations.