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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.

The Friday List: 10 Things You Need to Know About Regulation Best Interest

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.

A few weeks ago, the SEC proposed Regulation Best Interest, which requires a broker to act in the best interest of each retail customer at the time the recommendation is made, notwithstanding the broker’s own financial interests.  The SEC has been pondering a broker fiduciary rule for many years but lost the regulatory race to the Department of Labor, which promulgated its own rule.  Now that the 5th Circuit has vacated the DoL Rule and the SEC has proposed its own rule, the current state of the law is unclear.  Regardless, we have read the release and offer our list of the 10 things you need to know about proposed Regulation Best Interest.

10 Things You Need to Know About Regulation Best Interest

  1. Reasonable basis.  A broker must have a reasonable basis that the recommendation is in the best interest of the client.
  2. Applies to retail customers.  A retail customer is defined as a person who uses the recommendation primarily for personal, family, or household purposes.
  3. “Recommendation” remains the same.  The proposal does not seek to change the definition of “recommendation,” preferring to defer to the current FINRA interpretations.
  4. No definition of “best interest”.  In 400+ pages, the SEC never defines the term “best interest” when proposing Regulation Best Interest.
  5. More than suitability, less than fiduciary.  Regulation Best Interest combines elements of the current suitability standard (e.g. suitable at time of transaction) with a few fiduciary-like elements (e.g. disclosure).
  6. Fails to harmonize RIA and BD standards.  Advocates of a uniform fiduciary standard want a single standard so that consumers are not confused by the differing standards of care applicable to advisers vs. brokers.  This proposal fails to ensure a “uniform” standard.
  7. Disclosure of conflicts of interest.  The most significant new requirement is that brokers must disclose (or mitigate) conflicts of interest.
  8. Must consider series of transactions.  Expanding traditional suitability, a broker must also consider the series of recommended transactions.
  9. Product neutrality not required.  Brokers can make more money on recommended products, including proprietary products, so long as the conflict is properly disclosed and mitigated.
  10. Regulation Best Interest is not law.  Comments are due on this controversial proposal by August 7, 2018.  Thereafter, we expect much debate and re-drafting before any final rule is adopted.

The Friday List: The Risks of the Dual-Hat Model for CCO and/or FINOP

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.

We hate the practice of dual-hatting i.e. appointing a senior executive with non-regulatory responsibilities as a Financial and Operations Principal or Chief Compliance Officer.  The SEC, through several enforcement actions, also appears to dislike the practice, which it alleges to have caused a wide variety of regulatory breakdowns.  The dual-hat model also exposes senior executives to direct personal liability.  In today’s list, we offer 10 significant risks of the dual-hat model identified in a series of SEC enforcement actions.  For reference, we have included links to our blog posts where you can read more.

 

10 Risks of the Dual-Hat CCO or FINOP Model

  1. Failure to supervise executive conduct.
  2. Taking undisclosed fees and/or overbilling.
  3. Under-resourcing the compliance function.
  4. Ignoring cited exam deficiencies.
  5. Engaging in conflicts of interest.
  6. Inadequate disclosure.
  7. Not conducting required annual compliance reviews.
  8. Using a stock “off-the-shelf” compliance manual.
  9. Failure to implement compliance policies and procedures.
  10. Not properly calculating net capital.

The Friday List: 2018 Examination Priorities

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.

Both FINRA and the SEC OCIE staff recently released their 2018 examination priorities.  Today’s list synthesizes their missives into the 10 most significant regulatory priorities for investment management firms.   Several of these priorities are new this year including cryptocurrency, wrap fee programs, and thinly-traded securities.  Others such as AML, suitability and best execution are regulatory greatest hits that appear nearly every year.   Compli-pros should use these letters to prepare their compliance programs and exam readiness.

 

10 Most Significant 2018 Examination Priorities

 

  1. Disclosure of fees and expenses: Both OCIE and FINRA champion full transparency of fees and expenses so that clients can make informed decisions and understand possible conflicts of interest.
  2. Cryptocurrency:  Expect a lot of attention paid to initial coin and cryptocurrency offerings including recommendations, disclosure, volatility, and security.
  3. Cybersecurity:  The regulators want to ensure that firms implement adequate cyber policies and procedures to protect client information and data systems.
  4. AML and KYC:  This is an area that both regulators have identified for many years, although the focus has moved to customer due diligence and firms’ gatekeeper role to keep securities markets safe.
  5. Protecting senior investors: Both regulators want to protect senior investors.  The SEC focuses on recommendations to retirement accounts.  FINRA will review compliance with rules to prevent exploitation.
  6. Wrap fee programs: The SEC continues its persecution and prosecution of wrap fee programs, including due diligence, best execution, and conflicts.
  7. Thinly-traded ETFs and microcaps:  The regulators have raised the red flag about recommending thinly-traded securities that are subject to market manipulation and pay exorbitant commissions.
  8. High risk brokers:  FINRA wants firms to enhance hiring and supervision practices to keep bad actors out of the industry.
  9. Suitability: Firms must implement procedures to vet products and train reps.
  10. Best execution:  FINRA is particularly concerned about order-routing practices and resulting conflicts of interest.