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The Friday List: The 10 Most Significant Changes in the Proposed Adviser Advertising Rule

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

  1. Expanded Definition of “Advertisement”. The proposed rule applies to “any communication, disseminated by any means.”  This definition includes all digital and social media communications.
  2. 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.
  3. 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.
  4. Performance Periods. Retail advertisements (see below) must include one, five, and ten-year (or life if shorter) performance numbers.
  5. Extracted Performance Restricted. A presentation of a subset of portfolio performance must include (or offer to provide) the results of all portfolio investments.
  6. 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.
  7. 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.
  8. 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.
  9. Designated Reviewer. A designated employee (presumably the Chief Compliance Officer) must review and approve all advertisements.
  10. 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 Friday List: The 10 Most Significant Investment Adviser Proxy Voting Requirements

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.

On Wednesday, the SEC issued guidance to investment advisers about the contours of their fiduciary responsibility when voting proxies on behalf of their clients.  SEC Commissioner Elad Roisman summarized the SEC’s view: “Advisers who vote proxies must do so in a manner consistent with their fiduciary obligations and, to the extent they rely on voting advice from proxy advisory firms they must take reasonable steps to ensure the use of that advice is consistent with their fiduciary duties.”  Today, we offer the 10 most significant investment adviser proxy voting requirements.

The 10 Most Significant Investment Adviser Proxy Voting Requirements

  1. Fiduciary Responsibility. Proxy voting is part of an investment adviser’s fiduciary responsibility, which requires the adviser to vote proxies in the best interest of every client based on a reasonable understanding of the client’s objectives.
  2. Implied Duty. If the agreement with a client does not otherwise limit an adviser’s proxy voting obligations, the adviser has the implied duty to vote proxies on behalf of the client.
  3. Consider Cost of Voting. An adviser may refrain from voting if it would be in the best interest of the client (e.g. voting would impose unnecessary costs on the client.)
  4. Policies and Procedures. Advisers must adopt, implement, and test policies and procedures to ensure that the firm votes proxies in the best interest of its clients.
  5. Can’t Outsource Liability. Hiring a third party proxy firm does not relieve an adviser of its fiduciary obligations to ensure every vote is cast in the best interest of clients.
  6. Reasonable Investigation. Advisers must conduct a reasonable investigation into matters on which the adviser votes, whether or not delegated to a proxy voting firm.
  7. Client-Specific Policies. Advisers should scrutinize whether applying the same voting policy to all clients, regardless of size or type, would satisfy the fiduciary responsibility and consider client-specific policies.
  8. Corporate Actions. Significant events (e.g. corporate events, contested director elections) require a more detailed analysis than more routine events.
  9. Service Provider Oversight. Advisers must conduct a detailed initial and ongoing due diligence of third party proxy advisory firms that includes an investigation into staffing, policies and procedures, technology, and methodologies.
  10. Obligation to Update. The adviser should require the proxy advisory firm to update the adviser regarding any relevant business changes.

The Friday List: 10 Reasons Outsourcing Compliance Beats Hiring an In-House Chief Compliance Officer

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. 

Over the last several years, an increasing number of investment management firms have chosen to outsource the Chief Compliance Officer role and associated compliance function.  In our experience, these firms make this decision for rational business reasons based on an assessment that outsourcing the compliance function is better than hiring a full-time employee.  Usually, firms consider outsourcing because of an external event such as a less-than-perfect SEC exam or an institutional due diligence process that suggests unknown weaknesses.  Some firms decide to outsource after yet another internal CCO changes jobs.  Other times, firm management simply gets frustrated with the inherent limitations of the one internal compliance person.  Regardless, we list below the top 10 reasons investment firms should outsource the CCO role and compliance function rather than hire an in-house employee.

10 Reasons Outsourcing Compliance Beats Hiring an In-House CCO

  1. Experience: A team of professionals can draw on decades of aggregate compliance experience to address a firm’s regulatory challenges.
  2. Knowledge: No one person can provide the depth of knowledge of several compliance professionals working collaboratively. 
  3. Independence: A third party firm offers investors and other stakeholders an independent assessment of a firm’s compliance strengths and weaknesses.
  4. Industry best practices: A multi-person team working with multiple clients across the country has the industry vision to inform the compliance program.
  5. Accountability: A compliance firm stands behind its work and advice with a service level agreement and professional liability insurance. 
  6. 24/7/365 support: A person may take PTO, but a team of professionals is available at all times for any emergency including unplanned client due diligence and SEC exams.
  7. Personal liability: Serving as CCO involves significant personal liability, which is better left to professionals that understand and accept the regulatory and career implications. 
  8. Frees up internal resources: Internal personnel can focus on core activities such as portfolio management and fund-raising.   
  9. Management: Senior managers can avoid the confusing and time-consuming process of hiring, retaining, and managing an internal CCO, only to start the process anew in the event the CCO leaves. 
  10. Cost savings: Because of program efficiencies, outsourcing generally costs less than hiring a full-time employee. 

The Friday List: Common Problems with Hypothetical Backtested Performance


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. 

Every year, the SEC publishes a handful of enforcement cases alleging that an investment adviser violated the advertising and marketing rules by misusing hypothetical backtested performance (HBP).  In our experience with exams, the SEC nearly always cites deficiencies when firms use HBP in marketing.  Although there is no rule specifically prohibiting the use of HBP, our position is that firms should never use HBP.  To support our view, we have highlighted below 10 of the most common HBP failings and cite to specific SEC actions (click on links).  As a side note, most institutional investors with whom we work look very critically at HBP because they also understand the limitations. 

10 Common Problems with Hypothetical Backtested Performance

  1. Failure to disclose limitationsOne common allegation is that firms fail to fully disclose the limitations on HBP.  
  2. Insufficient backup dataThe SEC will seek to verify that you have maintained adequate backup data to support your HBP claims.
  3. Cherry-picking time periodsMany firms have violated the SEC marketing rules when they cherry-pick a specific time period that makes their HBP look better
  4. Misleading disclosuresHidden or confusing HBP disclosure will draw the SEC’s enforcement interest.  
  5. Retrospective model changesFirms can’t keep tinkering with their models to improve the HBP results.
  6. Using incorrect historical market inputsThe SEC can verify actual market data from past time periods, so make sure you use the correct numbers.  
  7. Applying different modelsThe SEC has raised red flags when HBP differs significantly from audited or live performance information applying the same models.
  8. Using the wrong model rulesFirms have gone astray by applying different model rules to the backtested data than they use to manage real accounts
  9. Investments didn’t existThe SEC will call out HBP that includes investments that were not available at the time.  
  10. Faulty algorithmCheck the algorithm used, because faulty programming can result in inflated performance numbers.  

The Friday List: Effects of the Government Shutdown on the Investment Management Industry


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. 

As the partial federal government shutdown continues, the investment management industry is beginning to feel the effects of reduced SEC operations.   The people most affected are those furloughed SEC employees who lose compensation every day the shutdown continues.  However, the entire industry has been affected.  Below is our list of the top 10 effects of the partial federal government shutdown. 

Effects of the Government Shutdown

  1. New product approvals.  New products including registration statements must await approval until the furloughed workers return.
  2. Exams.  The OCIE staff has delayed ongoing exams until the shutdown ends.  It is unclear whether the shutdown will reduce the total number of exams. 
  3. Enforcement litigation.  While the SEC continues to conduct market surveillance, ongoing litigation that is not time-sensitive will be delayed.
  4. Regulatory information.  The SEC is not posting regulatory information or interpretations on its website during the shutdown
  5. Exemptive applications/No Action Letters.  Requested exemptive applications and no-action letters seeking relief from the black letter rules cannot go forward without SEC staff.
  6. New rules.  The SEC is not reviewing potential new rule initiatives or comments to current proposals. 
  7. Travel.  Many of our clients and colleagues have delayed travel to discuss new initiatives or to attend meetings. 
  8. Service providers.  With asset managers unable to launch new products, service providers such as lawyers and fund administrators must wait for their clients to go forward. 
  9. Conferences.  It is unclear whether SEC officials will attend this winter’s industry conferences where they traditionally provide some guidance.  Even if they do attend, any guidance will necessarily depend on how long the shutdown continues. 
  10. Industry outreach.  The SEC will likely delay industry outreach to management, compliance professionals and boards.

The Friday List: My 2019 Predictions

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. 

As reported last week, I went 8-2 on my 2018 regulatory predictions, bringing my mark to 22-15-3 over the last four years.  For the upcoming year, I want to take a few more chances and swing for the fences on a couple of predictions. While this may lower my percentage, I hope my readers and our clients will reward the boldness (perhaps by reading my new book: The Compliance Advantage: Ten Must-Know Trends to Protect Your Investment Firm (available on Amazon). 

Predictions for the 2019 Regulatory Year

  1. The SEC will propose a comprehensive adviser marketing/advertising rule.  Last year, we accurately predicted that the Enforcement Division would focus on marketing and advertising cases.  We predict that the Division of Investment Management will use these cases as the justification to propose a new rule addressing adviser marketing practices.
  2. The SEC will re-propose the broker best interest standard.  Responding to industry comments, the SEC will re-propose the rule and make it closer to an adviser fiduciary standard but stopping just short of reconciling the two standards. 
  3. The Enforcement Division will bring several significant cases alleging violations of the solicitor rule.  OCIE has already cited widespread noncompliance with the solicitation rule (206(4)-3), which limits how advisers can pay solicitors for recommending their services.  We expect that the Enforcement Division will follow up with significant litigation. 
  4. The SEC will liberalize the private offering rules.  Look for the SEC to raise the accredited investor definition, change offering exemptions, or seek new private offering categories. 
  5. OCIE will examine at least 20% of advisers.  Chairman Clayton committed to increasing adviser reviews to respond to media and Congressional criticism that the SEC needs to enhance industry supervision.  The SEC reviewed 15% of advisers last year.  This will be the year that the SEC hits the 20% mark. 
  6. The SEC will bring significant cases against independent fund directors.  Both OCIE and the Enforcement Division have increased scrutiny of registered funds and their management.  I foresee that the Enforcement Division will go beyond the fund sponsors and look to hold independent directors accountable for regulatory failures. 
  7. The SEC will allege securities fraud in secondary market private equity transactions.  Both private equity sponsors and third parties have expanded the secondary market for private equity investments.  Because of the information imbalance between buyers and sellers, we expect that the SEC will seek to even the playing field by bringing securities fraud cases.   
  8. The SEC will approve a registered crypto fund.  I won’t try to predict which fund, or the conditions imposed, but I believe the SEC will green-light at least one crypto-based registered fund.  I suspect it will be sponsored by a (very) large firm. 
  9. The Supreme Court will decide that digital tokens are not securities and that an ICO is not a securities offering.  This issue is roiling the lower courts and the industry.  Eventually, the Supremes will have to end the uncertainty.  Although I think there are good arguments on both sides, I think this Supreme Court will rule against SEC regulation. 
  10. The SEC will expand the whistleblower program.  The SEC will expand the program to include criminal actions prosecuted by the Department of Justice as well as state enforcement actions. 

The Friday List: 10 Adviser Marketing Practices to Avoid

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.

Last year, the SEC’s Office of Compliance Inspections and Examinations issued a Risk Alert warning advisers to review their marketing and advertising practices.  More recently, OCIE alerted advisers to widespread noncompliance with the solicitation rule.  Meanwhile, the Enforcement Division has brought several actions alleging that adviser marketing practices violated applicable law.   With this increased scrutiny, advisers should re-assess the following marketing practices to avoid material exam deficiencies or enforcement actions:

 

10 Adviser Marketing Practices to Avoid

  1. Hypothetical Back-Tested Performance.  The SEC has consistently targeted the use of hypothetical, backtested performance, and the Enforcement Division has brought numerous cases.
  2. Gross Performance.  Although firms can present gross performance in a few limited situations, most should firms should always present performance information net of fees.
  3. Misrepresenting Investment Strategy.  Sales personnel should not make representations about investment products that are inconsistent with disclosure documents.
  4. Receiving Revenue Sharing.  The SEC will heavily scrutinize undisclosed revenue sharing that incent advisers to sell certain products.
  5. Faulty GIPS Compliance.  Claiming compliance with GIPS (CFA Institute) performance standards but failing to actually comply with those standards will draw the ire of the regulators.
  6. Cherry-Picking Performance.  The SEC will challenge firms that only show good performance of certain past specific recommendations.
  7. Testimonials.  Rule 206(4)-1(a)(1) specifically prohibits the use of testimonials. Yet, too-clever advisers keep trying to use them, resulting in enforcement actions.
  8. Lying about Credentials.  Don’t present credentials that are inconsistent with your actual work experience in an effort to market greater expertise.  
  9. Inflating AUM.  Avoid using unverifiable assets under management totals in marketing materials or on Form ADV.
  10. Claiming Clean Compliance.  When asked in an RFP to describe compliance deficiencies identified during exams, do not ignore the question or say “none” unless it’s true.

The Friday List: 10 Topics the Division of Investment Management Should Reconsider

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.

Last month, SEC Chairman Jay Clayton said that SEC no-action letters and other staff statements “are nonbinding and create no enforceable legal rights or obligations.”  He instructed the SEC staffs to “review whether prior staff statements and staff documents should be modified, rescinded or supplemented in light of market or other developments.”  More recently the Director of the Division of Investment Management, Dalia Blass, said that her division is reviewing and assessing prior staff statements.  Both Mr. Clayton and Ms. Blass invited engagement and input from the public.  With that invitation, we offer ten topics that the Division of Investment Management should reconsider as it assesses its staff positions:

 

10 Topics the Division of Investment Management Should Reconsider

  1. Custody:  The custody rule and the reams of staff FAQs have only confused the industry and ensured massive inadvertent noncompliance.  If the staff only tackles one problem, this is it.
  2. Valuation:  Please offer clear guidance on the fair valuation of securities that are not publicly traded.  The current regime is too subjective, relying on accounting interpretations and shifting market information.
  3. Proxy Voting:  Firms spend significant resources complying with the proxy voting recordkeeping and supervision requirements.  Do these rules really protect clients and shareholders?
  4. Private Funds:  Restricting private funds to 100 holders or qualified purchasers is overly restrictive.  The staff should also reconsider the definition of “accredited investor.”
  5. Leverage:  With the advent of derivatives and other forms of innovative investment products, the staff should modernize its positions on permitted leverage.
  6. Advertising:  The staff has not materially changed the adviser advertising rules in 30 years.  The new media world requires some new rules.
  7. Code of Ethics:  A significant percentage of compliance time and resources is spent on personal securities transaction compliance.  The staff should consider other less onerous schemes to prevent and punish unlawful personal trading.
  8. Affiliate Transactions:  Scholars have written entire treatises on the definition of “affiliate transaction” under the Investment Company Act.  It may be the most confusing definition in the securities laws.
  9. Disclosure:  Few retail investors read prospectuses or Form ADV.  One way to make clearer and more readable documents is too exempt issuers from securities law liability.
  10. Wrap Programs: The SEC has brought dozens of actions against wrap programs.  We would recommend that the staff adopt some definitive rules that the industry could follow.

The Friday List: 10 Reasons Why the SEC Hates Wrap Programs

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.

The SEC hates wrap programs.  Nobody at the SEC has actually said that, but the regulator’s actions support that conclusion.  Nearly every year, OCIE targets wrap programs as an exam priority.  Over the last couple of years, the Enforcement Division has brought case after case alleging that wrap programs violated applicable provisions of the Advisers Act.  In response, we have advised compli-pros at firms that offer wrap programs to conduct serious reviews and testing to make sure their programs don’t become Enforcement examples.  Today, we offer 10 reasons why the SEC hates wrap programs.

 

10 Reasons Why the SEC Hates Wrap Programs

  1. Weak due diligence: Wrap Sponsor Pays $97 Million for Inadequate Due Diligence
  2. Favoring affiliates:  Adviser Didn’t Fully Disclose Financial Incentive to Recommend Affiliated Wrap Program
  3. Reverse churning: Wrap Sponsors to Pay over $9.5 Million to Settle Share Class and Reverse Churning Charges
  4. Overbilling: Large Wrap Sponsor Pays $18.3 Million for Compliance Problems in Business Sold 8 Years Ago
  5. (Not) best execution: Wrap Sponsors Fined for Failing to Disclose Trading Away Commissions
  6. Step-out trading: Wrap Sponsor Did Not Evaluate Trading Away by Portfolio Managers
  7. Trading away: Wrap Sponsor Fined for Failing to Monitor Trading Away Practices
  8. Double-charging: Failure to Heed Compliance Consultant’s Recommendations Results in Enforcement Action
  9. Lower share classes available: Wrap Sponsor Failed to Update Compliance Policies for Lower Share Classes
  10. Inadequate Form ADV disclosure: SEC Imposes $300,000 Fine for Wrap Program ADV Missteps

The Friday List: 10 Examples of Brokers Behaving Badly

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.

The debate about the now-vacated DoL fiduciary rule and the recently proposed Regulation Best Interest continues.  We have argued that a uniform fiduciary standard should apply to both retail brokers and advisers.  Why?  We accept the position that retail consumers should not have to hire a lawyer to determine the advice standards to which his/her financial professional adheres.   More significant, however, is that brokers behave badly and need a higher standard.  An academic study that was first published in 2016 reported that 7% of broker-advisers have misconduct records, prior offenders are 5 times more likely to engage in misconduct, and 44% of brokers fired for misconduct are re-employed within a year.  The authors concluded: “We find that financial adviser misconduct is broader than a few heavily publicized scandals.”   They also argued that a more stringent standard would help the industry by improving the low reputation of financial professionals.  Our reporting of cases also shows endemic broker misconduct.  In today’s list, we highlight examples of brokers behaving badly, which should inform the debate on a uniform fiduciary standard.

 

10 Examples of Broker Behaving Badly

  1. Stealing from clientsA broker exploited a weakness in his firm’s control systems that allowed third party disbursements, enabling him to misappropriate $7 Million from clients.
  2. Churning.   A broker recommended an unsuitable in-and-out trading strategy that generated significant commissions.
  3. Misrepresenting disciplinary recordA broker’s website claimed he never had a complaint, even though several customers filed and settled complaints over the course of an 8-year period.
  4. Misusing client information. A broker shared nonpublic personal information (including holdings and cash balances) about clients with a person no longer affiliated with his firm.
  5. Revenue sharing.   A broker received undisclosed revenue sharing on mutual fund trades from the clearing broker.
  6. Undisclosed markups/markdownsAn interdealer failed to disclose markups and markdowns on securities traded for clients.
  7. Commission kickbacksA trading supervisor demanded commission kickbacks from junior traders to whom he assigned clients.
  8. Pump-and dumpA broker engaged in an ongoing penny stock pump-and-dump scheme.
  9. Bribing public officials.    A broker spent nearly $20,000 on hotels, meals and concert tickets to bribe a public plan official to secure brokerage business from a public plan.
  10. IPO kickbacks.   A broker and his client conspired in a kickback scheme whereby the customer would pay back 24% of his profits in exchange for preferred IPO and secondary offering allocations.