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Share Class Disclosure Initiative Ensnares 79 Firms for $125 Million

The SEC announced 79 settled enforcement cases whereby investment advisers agreed to disgorge more than $125 Million in the aggregate for recommending higher-cost mutual fund share classes and receiving revenue sharing.   The cases arose from last year’s Share Class Disclosure Initiative launched, which encouraged firms to self-report to avoid penalties.  The SEC charges that the firms recommended mutual fund share classes that were more costly than other available classes so that the firms or their personnel could receive 12b-1 fees in their capacities as broker-dealers or registered representatives thereof.  Each charged firm “has also undertaken to review and correct all relevant disclosure documents concerning mutual fund share class selection and 12b-1 fees and to evaluate whether existing clients should be moved to an available lower-cost share class and move clients, as necessary.”

Firms that take revenue sharing from fund companies should consult counsel about their self-reporting options.  Also, whether or not your firm self-reports, you should undertake the review of all relevant disclosure that the SEC has mandated. 

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. 

RIA Platform Will Pay $1.1 Million to Settle Fund Share Class Charges

An RIA platform was ordered to pay over $1.1 Million in penalties and disgorgement for recommending mutual fund share classes that charged 12b-1 fees when lower share classes of the same funds were available.  Although the firm disclosed that advisers could receive 12b-1 fees from the sale of mutual funds, the SEC faults the firm for failing to disclose that the advisers had a conflict of interest because they could recommend lower-fee share classes that did not pay revenue sharing.  The SEC also charged the firm with failing to implement its policies and procedures and with neglecting to ensure best execution.  An SEC Enforcement official warned, “Advisers must be vigilant in disclosing all conflicts of interest arising from compensation received based on investment decisions made for clients” and that the Enforcement Division is “continuing [its] efforts to stop these violations and return money to harmed as quickly as possible.”

We expect several enforcement actions this year based on the failure to offer the lowest mutual fund share class available.  We recommend that advisers conduct an internal reviews of recommendation practices and take action to reimburse clients. 

Private Equity Firm Overcharged Clients for 16 Years

A private equity firm agreed to pay a $400,000 fine and reimburse clients for overcharging fund investors over a 16-year period.  According to the SEC, the PE firm did not proportionally allocate broken deal, legal, consulting, insurance, and other expenses to co-investors and employee co-investment funds, thereby overcharging investors in their flagship funds.  The SEC also accuses the firm of paying portfolio company consulting fees to co-investors, which resulted in lower fee offsets to the detriment of flagship fund investors.  The firm voluntarily agreed to reimburse investors for the expenses and the fees following discovery of the misconduct during a 2016 SEC exam.  The SEC charges the firm with failing to implement a reasonable compliance program as well as the Advisers Act’s antifraud rules. 

If the firm had implemented a reasonable compliance program, discovered the overcharging, and reimbursed clients before the SEC uncovered the violations during an exam, it may have avoided the public enforcement action and resulting fine.  Also, a reasonable compliance program may have avoided the overcharging in the first place.  C-suite executives should re-think the cowboy mentality that ignores compliance until the SEC or a client makes them change.  It’s much less expensive to change the oil every 5000 miles than to replace the engine if it seizes. 

Wrap Sponsor Did Not Evaluate Trading Away by Portfolio Managers

The SEC fined a wrap sponsor and ordered it to enhance its policies and procedures in connection with failures to evaluate and disclose trading away practices by third party portfolio managers.  The SEC, which reviewed the firm’s practices back to 2008, asserts that 40% of the portfolio managers stepped-out trades to non-participating brokers, resulting in additional costs to the wrap client.  The SEC faults the sponsor for neglecting to (i) provide historical trading away information about the portfolio managers to participating advisers so that they could conduct adequate suitability reviews and (ii) disclose the costs of trading away practices.  The SEC charges violations of the compliance rule (206(4)-7) for failing to adopt reasonable policies and procedures.

OUR TAKE: We have warned that the SEC does not like wrap programs.  If your firm insists on operating a wrap program, we would recommend a strict policy against trading away with a non-participating broker-dealer, unless the portfolio manager can document the execution benefits on a trade-by-trade basis.  Of course, the wrap sponsor must disclose the trading away information as soon as possible to participating RIAs and wrap clients.


CCS’s Dalkin Reports on Private Fund Compliance Forum 

Jocelyn Dalkin of Cipperman Compliance Services recently attended the Private Fund Compliance Forum in New York.  Sponsored by Private Equity International, the forum brings together legal and compliance professionals from the biggest firms to discuss investment management regulatory issues.  Keynote speaker David Sorkin (KKR) advised compli-pros to continuously monitor regulatory and business changes to adapt compliance programs in real-time.  A panel of compliance experts from several large PE firms discussed how to allocate compliance responsibilities both internally and externally.  Other panels considered SEC exams, regulatory priorities, and how to address conflicts of interest.  Feel free to contact Jocelyn if you want more information.

Link to Summary


Thompson Hine and Cipperman Podcast Identifies Top Regulatory Issues

Cassandra Borchers, a partner at Thompson Hine, and Todd Cipperman recently sat down to discuss the 10 most significant regulatory trends for the investment management industry.  In their podcast, Todd and Cassandra discuss an investment adviser’s fiduciary responsibilities, including Regulation Best Interest and wrap programs, senior executive liability, service provider accountability, compliance programs, whistleblowers, and cybersecurity.  Their conversation is based on Cipperman’s upcoming book that delves deeper into these Top 10 investment management regulatory trends.  Thompson Hine LLP, a full-service business law firm with approximately 400 lawyers in 7 offices, has received numerous awards for innovation, service and expertise.  Cipperman Compliance Services leads the investment management industry in providing outsourced compliance services.


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: 10 Things to Know about the DoL Fiduciary 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.

Last Monday (May 22), the Department of Labor issued guidance on the implementation of the long-debated Fiduciary Rule.  Most significantly, the DoL did not further delay the basic concept that financial institutions and advisers must apply a best interest standard to advice for IRAs and other retirement accounts.  However, the DoL did back off of some of some of the compliance requirements for the rest of this year and plans to collect more information.  Below is a list of the 10 things you need to know right now about the DoL Fiduciary Rule.


10 Things to Know about the DoL Fiduciary Rule


  1. Applies to IRAs: The DoL Fiduciary Rule applies to investment advice concerning IRAs, ERISA plans, and plans covered by Section 4975 of the Tax Code.
  2. Best Interest standard starts June 9: Beginning June 9, financial institutions and advisers to covered plans must provide advice in the retirement investor’s “best interest,” which includes a duty of prudence and loyalty.
  3. BIC exemption compliance starts January 1: The extensive compliance requirements of the Best Interest Contract (BIC) exemption, which would apply to non-level fee products, are not required until January 1, 2018.
  4. DoL expects changes by January 1: During the Transition Period (June 9-January 1), the DoL will collect additional information from the industry to determine how compliance practices such as the use of mutual fund “clean shares” should re-shape the Rule.
  5. Proprietary products with commissions permitted: During the Transition Period, firms can recommend proprietary products with commissions so long as they satisfy the best interest standard.
  6. Need policies and procedures: The DoL expects firms to adopt policies and procedures necessary to ensure compliance with the best interest standard.
  7. Robo-advisers can rely on BIC exemption: Robo advisers may rely on the BIC Exemption during the Transition Period to ensure compliance with the Rule.
  8. Investment advice narrowly defined: Investment advice, for purposes of the Rule, does not include plan information or general financial, investment and retirement information.
  9. Can rely on written representations from intermediaries: The Rule does not apply if an independent fiduciary provides written representations (including negative consent) that the fiduciary is a bank, insurance company, BD, RIA, or independent fiduciary managing at least $50 Million.
  10. DoL will focus on compliance over enforcement: The DoL says it will prioritize compliance over enforcement during the Transition Period so long as firms work diligently and in good faith to comply with the Rule.