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Adviser and CCO Son Were Unaware of Advisers Act

 

The U.S. District Court for the Northern District of Illinois ordered an investment adviser to pay over $1.8 Million in disgorgement and penalties for multiple violations of the Investment Advisers Act.  The SEC asserts the adviser ignored the Advisers Act’s custody, recordkeeping, valuation, and disclosure rules while commingling assets and engaging in insider transactions.  When confronted with the deficiencies following an SEC exam, the firm’s principal said that he was unaware of the existence of the Investment Advisers Act or the duties it imposed upon the firm and its principals.  The founder’s son who served as Chief Compliance Officer was barred from the industry earlier this year.

Ignorance of the law is no excuse, and naivete will not insulate a Chief Compliance Officer from liability.  When operating in a regulated industry, failure to retain competent regulatory advisers will result in a date with a federal judge. 

REIT Manager Overpaid Itself When Calculating Incentive Fee

 A large REIT manager, together with its CEO and CFO, agreed to pay over $60 Million in disgorgement, interest and penalties for inflating incentive fees and taking reimbursement for significant expenses.  The SEC asserted that the defendants, contrary to disclosures and agreements, used their insider positions to calculate incentive fees in a manner that unjustly enriched themselves over the investors to whom they owed a fiduciary duty.  The SEC also charged the defendants with collecting millions in expense reimbursements as part of various merger transactions.  The SEC accused the defendants of securities fraud and falsifying books and records.

Firms should use some third party (e.g. fund administrator, LPA committee) to calculate, or at least confirm calculations, of fees collected from clients.  When management can exercise arithmetic discretion to pay itself, regulators will scrutinize the calculations.      

CCS Releases Summaries of Regulation Best Interest, Form CRS, and Companion Interpretations

 Last month, the SEC adopted Regulation Best Interest for broker-dealers making recommendations to retail clients and adopted the new Form CRS requiring advisers and broker-dealers to provide standardized disclosure to retail customers.  Companion releases included an interpretation of an adviser’s fiduciary responsibilities as well as the contours of the “solely incidental” exception to adviser registration for broker-dealers.  The CCS team has spent the last few weeks reviewing the new regulatory information and offer the following summaries.  Please feel free to contact Jay Haas, Mark DeAngelis, Suzette Hagan or Larry Clay directly if you want to ask any deeper questions.

 

Regulation Best Interest: The CCS Summary by Jay Haas

Form CRS: The CCS Summary by Mark DeAngelis

Fiduciary Interpretation: The CCS Summary by Suzette Hagan

“Solely Incidental”: The CCS Summary by Larry Clay

Adviser Benefited When Clients Invested in Its Lender

An investment adviser and its principal agreed to pay over $1.3 Million in disgorgement, interest and penalties for misleading clients about the adviser’s relationship with a lender. Following the action, the adviser was sold to another adviser, and the principal was barred from the industry. According to the SEC, the adviser, through the principal, advised clients to invest in the lender’s promissory notes without telling them that the loan’s repayment terms depended on the amount invested. The adviser characterized its relationship with the lender as a “strategic affiliation.” The SEC also maintains that the principal misled a client into investing in the adviser for the purpose of acquiring other advisers but the client’s investment was instead used to pay the principal’s personal expenses. The scheme was uncovered following the SEC’s action against the lender for fraudulent securities sales.

Don’t engage in direct transactions with your clients. We do not believe any amount of disclosure could adequately mitigate such a significant conflict of interest and resulting breach of fiduciary duty.

Massachusetts Proposes Its Own Fiduciary Rule

The Massachusetts Securities Division has proposed a fiduciary rule for all brokers and advisers for the provision of recommendations, advice and selection of account type. The proposed rule would require that all recommendations and advice be made in the best interest of customers and clients without regard to the broker/adviser’s interests. The MSD asserts that the suitability standard has not sufficiently protected customers against sales contests, churning, risky products and bad brokers. The MSD also criticizes the SEC’s recently adopted Regulation Best Interest because it (i) does not fully protect investors; (ii) relies too much on disclosure; and (iii) does not resolve customer confusion about the applicable standard of care. The MSD is accepting comments until July 26.

The expansive MSD proposal includes any type of financial adviser, any type of customer, and any type of advice. If adopted, the MSD’s rule would set up a court case about whether Regulation Best Interest preempts state fiduciary rules.

SEC Adopts Regulation Best Interest, Raising Broker Standard of Care

The SEC adopted Regulation Best Interest for broker-dealers that make recommendations to retail clients. Regulation Best Interest, intended to enhance a broker’s standard of care beyond suitability, requires a broker-dealer to act in the retail customer’s best interest and to refrain from transactions that favor the interests of the broker over the customer. The new rule requires disclosure as well as policies and procedures to ensure that brokers identify and mitigate conflicts of interest. The SEC also adopted new Form CRS that requires both advisers and brokers to provide retail customers with standardized information about their relationship, including services, fees, conflicts, standard of conduct, and disciplinary history. The SEC also issued an interpretation that addresses an adviser’s fiduciary responsibilities. Part of this regulatory package includes a refining of the “solely incidental” exception to adviser registration for brokers. Firms have until June 30, 2020 to comply with Regulation Best Interest, although the new interpretations apply immediately upon publication.

Let’s rename this “The Compliance Officer Full Employment Act.” Compli-pros at broker-dealers will have to rework all of their Written Supervisory Procedures, revise client agreements, create disclosures, and eliminate all prohibited conflicts. Compliance offices at investment advisers must address the new Form CRS requirement and implement new client onboarding procedures while figuring out the changes required by the investment adviser fiduciary interpretation. And, we only have 12 months to get this all done.

Fund Manager Did Not Conduct Adequate Investment Due Diligence

A formerly-registered fund manager was fined and censured for failing to conduct sufficient due diligence on underlying investments, which resulted in significant losses for the funds.  The fund manager invested $4 Million in a Norwegian trading strategy that promised repayment plus $40 Million in interest.  The fund manager represented that he conducted significant due diligence and that his financial advisers approved the investment.  In fact, the fund manager’s due diligence consisted of several phone calls and some Google searches.  Also, his lawyer, accountant, and fund administrator counseled further due diligence before investing. 

It is unclear how much due diligence is enough, but an investment that promises a 1000% return likely requires more than a few phone calls.  When financial professionals recommend a losing investment, they bear the burden of proving that their recommendations and due diligence satisfied their fiduciary and/or suitability obligations. 

Fund Manager Rigged Auction Process in Client Cross-Trades

A private fund and CDO manager agreed to pay over $400,000 to settle charges that it facilitated an illegal cross-trade that benefitted one client over another.  The SEC alleges that the firm sold securities held by its CDO client to its private fund at an artificially low price because the respondent failed to obtain required third-party bids.  Instead, the SEC asserts, based on a record of a phone conversation, that the firm asked friendly firms to provide false bids with assurances that they would not have to purchase the securities.  The private fund ultimately sold the securities at a significant profit.  The SEC also charged the firm’s Chief Operating Officer (who was fined and barred from the industry) for arranging the transactions and personally benefitting through his investment in the private fund.

Firms should avoid client cross-trades.  One side will always benefit, which gives rise to conflict of interest and favoritism allegations.  A fiduciary on both sides of a transaction may not be able to cure the conflict with any amount of disclosure. 

Adviser Pays $8.9 Million for Allowing Bankers to Influence Manager Selection

 

A large investment adviser affiliated with a global bank agreed to pay $8.9 Million in disgorgement, fines and interest for allowing affiliated investment banking relationships to influence the selection of a portfolio manager recommended to retail clients.  The adviser’s due diligence team had recommended the termination of a third party money manager because of personnel changes.  According to the SEC, senior executives, seeking an investment banking mandate with the third party, lobbied and influenced the due diligence group to delay the termination until after the awarding of the mandate.  The SEC faults the respondent for allowing this conflict of interest to influence its fiduciary obligations to recommend investment products in the best interest of its retail clients.

OUR TAKE: Compli-pros face an enormous challenges in large, global institutions to ferret out multi-lateral business relationships and ensure that the firm adequately observes its fiduciary obligations.