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The Friday List: My 2020 Predictions

Today, I offer the “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  The Friday Lists are an expanded “Our Take” on a particular subject, offering my unique (and sometimes controversial) perspective on an industry topic.

As reported last week, I went 4-4-2 on my 2019 regulatory predictions (26-19-5 over the last 5 years).  Below I offer my 2020 predictions, addressing Regulation Best Interest, closed-end funds, private equity, and compliance.  My one caveat is that my crystal ball is always cloudier during a presidential election year.  For example, if Jay Clayton or Dalia Blass decide to resign (not predictions although possible based on history), all bets are off as the SEC would grind to a regulatory halt.   Regardless, it should be an interesting regulatory year after all of the SEC’s 2019 new rules and proposals.  If you want more, please pick up a copy of my book: The Compliance Advantage: Ten Must-Know Trends to Protect Your Investment Firm (available on Amazon).

 

Prediction for the 2020 Regulatory Year

 

Lawsuits will delay implementation of Regulation Best Interest.   Multiple states as well as a coalition of financial planners have filed lawsuits challenging Regulation BI.  The lawsuits claim that the SEC exceeded its authority or did not follow Dodd-Frank’s requirements.  The financial planners argue that Regulation BI competitively discriminates.  We expect the SEC will have to delay implementation and perhaps re-write the rule in response.

Congress will propose/adopt legislation increasing SEC penalties.  Both Republicans and Democrats agree that corporate wrongdoers should face more severe punishments.  Increasing SEC penalties died when Rep. Hensarling stepped down and his efforts to overturn Dodd-Frank ended.  We expect Congress will resuscitate this initiative as it relates to SEC penalties.

New SEC rules will expand the closed-end fund market.  The SEC will adopt changes to the accredited investor definition and facilitate the registered closed-end fund offering process with modernized disclosure and tender offer rules.  The closed-end fund market will blossom, allowing retail investing into otherwise privately-offered securities.

The SEC will attack zombie funds.  As far back as 2014, the SEC raised concerns about “zombie” funds i.e. private funds that lock up investor redemptions but do not attract new assets or make new investments.  Late last year, the SEC brought a significant case alleging that the fund manager took illicit management fees even though it claimed the fund was illiquid.  We expect a number of significant enforcement actions against zombie funds this year.

The SEC will bring significant valuation cases against private equity firms.  As the retail market opens for private equity (see above), expect the SEC to scrutinize how PE firms value assets to calculate fees and performance.  The SEC has already shown its willingness to attack PE valuations.

OCIE will conduct an adviser advertising sweep.  It’s great news that the SEC recently proposed a modernized marketing and advertising rule.  We expect that the SEC will adopt the rule (in current or modified form) and then direct OCIE to conduct an industry sweep to ensure compliance.

Dual registrants will face a series of reverse churning cases.  The SEC has expressed concerns about dual registrants that put clients in fee-based programs when those clients would pay less in traditional brokerage accounts.  The SEC has brought a few cases charging reverse churning.  Expect a slew of these cases as sequels to the revenue sharing cases of the prior few years.

The SEC will allow the use of distributed ledger technology for securities settlement  and shareholder transactions.  The SEC has already allowed the beta test of a distributed ledger technology for securities settlement.  Although the SEC has raised significant regulatory concerns especially around custody, we expect that the use of these technologies will become more widely permitted and utilized this year.

The Enforcement Division will commence several cases against registered funds alleging inadequate fund compliance programs.  A recent OCIE sweep uncovered widespread regulatory failures by registered funds.  The industry has received its warning shot.  Expect litigation this year.

There will be a dramatic increase in the launch of niche ETFs.  Although ETF launches were down last year, we expect that the adoption of the new ETF rule will facilitate the launch of smaller, niche ETFs who will no longer have to obtain an exemptive order.

Top 20 Regulatory Alerts – 2019

The past year saw some watershed regulatory events that could reverberate for years to come.  The SEC adopted Regulation Best Interest as well as an ETF rule, both of which could have profound long-term implications for the investment management industry.  The SEC also proposed significant new rules about investment adviser marketing and advertising, derivatives, and the accredited investor definition.  The Enforcement Division once again set new records, while OCIE sweeps highlighted pervasive compliance breakdowns.  Meanwhile, the states have flexed their regulatory muscles.  Protection of personal information and its misuse continue to make headlines, and cryptocurrencies and blockchain technologies continue to make inroads into the financial markets.  I have been writing this blog nearly every day since 2008, and, regardless of market trend or political administration, I never run out of content.  I expect 2020 should be equally dynamic and impactful.

I have reviewed all the Alerts for 2019 and offer my list of the Top 20 Alerts of 2019.  You can decide for yourself by visiting our blog at https://cipperman.com/blog/.  If you want to dig deeper, you should read my book The Compliance Advantage: Ten Must-Know Trends to Protect Your Investment Firm (available on Amazon in paperback or Kindle format).

  1. SEC ADOPTS REGULATION BEST INTEREST, RAISING BROKER STANDARD OF CARE (6/6/19)
  2. SEC ENFORCEMENT DIVISION HITS NEW HIGH WITH $4.3 BILLION IN MONETARY PENALTIES IN FISCAL 2019 (11/7/19)
  3. SEC ADOPTS ETF RULE TO REPLACE EXEMPTIVE ORDERS (9/27/19)
  4. SEC PROPOSES NEW INVESTMENT ADVISER ADVERTISING RULE (11/5/19)
  5. INVESTMENT ADVISERS INCLUDED AS ACCREDITED INVESTORS IN SEC PROPOSAL (12/20/19)
  6. SEC SAYS THAT ICO IS NOT A SECURITIES OFFERING (4/4/19)
  7. SEC ALLOWS TESTING OF DISTRIBUTED LEDGER SYSTEM FOR SECURITIES SETTLEMENT (10/29/19)
  8. NEW YORK STATE EXPANDS SECURITIES ENFORCEMENT STATUTE (9/4/19)
  9. MASSACHUSETTS PROPOSES ITS OWN FIDUCIARY RULE (6/27/19)
  10. TECH COMPANY FINED $5.1 BILLION FOR FAILING TO DISCLOSE CUSTOMER DATA VIOLATIONS (7/25/19)
  11. ROBO FALSELY COMPARED PERFORMANCE WITH OTHER ROBOS (1/9/19)
  12. SEC INSPECTIONS STAFF CHIDES ADVISERS FOR WEAK SUPERVISION AND COMPLIANCE (7/24/19)
  13. SEC FINDS PERVASIVE REGULATORY FAILURES BY REGISTERED FUNDS AND BOARDS (11/12/19)
  14. MORE WORK FOR THE CCO IN SEC’S PROPOSED DERIVATIVES RULE (11/26/19)
  15. SEC OFFICIAL WARNS FIRMS NOT TO SHORTCHANGE COMPLIANCE (5/9/19)
  16. DUAL REGISTRANT FAILED TO CONVERT INACTIVE FEE-BASED ACCOUNTS TO BROKERAGE (9/19/19)
  17. PRIVATE EQUITY FIRM OVERCHARGED CLIENTS FOR 16 YEARS (1/3/19)
  18. PORTFOLIO MANAGER BLOWS UP HIS FIRM WITH SWAP PRICING SCHEME (7/19/19)
  19. PRIVATE FUND MANAGER TOOK MANAGEMENT FEES WHILE TELLING INVESTORS THAT FUND WAS ILLIQUID (10/28/19)
  20. HEDGE FUND FINED $5 MILLION FOR WEAK VALUATION PROCEDURES (6/5/19)

Top 5 Regulatory Alerts – Q4 2019

Here are our Top 5 Regulatory Alerts for Q4 2019 (October-December), ranked by significance.  We have also included the Top 5 most read Alerts.

Top 5 Regulatory Alerts – Q4 2019

  1. SEC ENFORCEMENT DIVISION HITS NEW HIGH WITH $4.3 BILLION IN MONETARY PENALTIES IN FISCAL 2019 (11/7/19)
  2. SEC PROPOSES NEW INVESTMENT ADVISER ADVERTISING RULE (11/5/19)
  3. INVESTMENT ADVISERS INCLUDED AS ACCREDITED INVESTORS IN SEC PROPOSAL (12/20/19)
  4. SEC FINDS PERVASIVE REGULATORY FAILURES BY REGISTERED FUNDS AND BOARDS (11/12/19)
  5. FINRA RELEASES EXAM FINDINGS (10/23/19)

 Most Read – Q4 2019

  1. SEC PROPOSES NEW INVESTMENT ADVISER ADVERTISING RULE (11/5/19)
  2. SEC WARNS FUND INDUSTRY ABOUT INACCURATE PERFORMANCE AND FEE DISCLOSURES (10/8/19)
  3. ADVISER AND CCO SON WERE UNAWARE OF ADVISERS ACT (12/2/19)
  4. CHIEF COMPLIANCE OFFICER, A FORMER SEC STAFFER, INDICTED FOR STEALING CONFIDENTIAL INVESTIGATION INFORMATION (10/24/19)
  5. SEC STAFF SUGGESTS THAT ADVISERS SHOULD REBATE REVENUE SHARING (10/21/19)

A Review of My 2019 Predictions

Every year, I offer my predictions on what will happen in the investment management regulatory world.  (I will publish my 2020 predictions next Friday.)  For 2019, I went 4-4-2 (ties for predictions that were mostly correct).  Last year, I went 8-2, which suggested I needed to stretch a bit more this year.  Over the last 5 years, I have gone 26-19-5 (4-6 in 2017, 4-3-3 in 2016 and 6-4 in 2015).  Below are the predictions I made in early January and how they turned out:

A Review of My 2019 Predictions

The SEC will propose a comprehensive adviser marketing/advertising ruleThe SEC proposed a comprehensive new investment adviser advertising rule in November.  The SEC has proposed broadening the definition of “advertising” and requiring standardized performance.  (1-0)

The SEC will re-propose the broker best interest standard.  I predicted that the SEC would propose a best interest standard short of an adviser fiduciary standard.  The SEC went one step further by actually adopting a heightened Regulation Best Interest that is not quite a fiduciary standard.  (2-0)

The Enforcement Division will bring several significant cases alleging violations of the solicitor rule.  There were several solicitation cases alleging violative facts such as failure to deliver proper disclosures.  (3-0)

The SEC will liberalize the private offering rules.  After publishing a broad concept release in June, the SEC’s December proposal would expand the definition of “accredited investor.”  (4-0)

OCIE will examine at least 20% of advisers.  OCIE examined only 15% of advisers this year. Even if you annualize results because federal workers were furloughed a month, they didn’t get to 20%.  It still remains an OCIE goal (4-1).

The SEC will bring significant cases against independent fund directors.  I am unaware of any significant cases against independent fund directors this year, other than the usual glut of hopeless 36(b) cases.  Regardless, there is some industry concern that the SEC will begin to scrutinize directors who approve questionable revenue sharing practices.  (4-2)

The SEC will allege securities fraud in secondary market private equity transactions.  There have been cases alleging secondary market fraud, but those cases have not been widespread in the PE market. With the surge in secondary market transactions this year, this prediction may be a year early.  We’ll call it a push. (4-2-1)

The SEC will approve a registered crypto fund.  It didn’t happen, although most of the industry remains hopeful.  The Division of Trading and Markets did allow a pilot program to test the use of a distributed ledger system for securities settlement.  Baby steps.  (4-3-1)

The Supreme Court will decide that digital tokens are not securities and that an ICO is not a securities offering.  This didn’t specifically happen, but, perhaps more surprising, the SEC’s Division of Corporation Finance allowed an initial coin offering without registration on the grounds that the underlying digital tokens were not securities.  If the SEC will concede this point, the issue may not reach the high court.  I am taking a tie on this one.  (4-3-2).

The SEC will expand the whistleblower program.  Despite recommending changes in 2018, the SEC never took action to expand the program in 2019.  Maybe, this comes up again next year.  (4-4-2)

Best of the Law Firms – December 2019 edition

Welcome to the December 2019 edition of the Best of the Law Firms.  In this feature, we recommend some of the best recent articles and analyses authored by top investment management lawyers.  These articles offer a more comprehensive review of the issues that we address in our daily “Our Take” alerts.

The laws firms have published some extensive articles on important investment management topics.  Dechert answers all our questions about ESG investing, Thompson Hine instructs on how to convert a mutual fund into an ETF, and Sadis tackles Opportunity Zone funds.  Groom always brings the ERISA good stuff, and Winston & Strawn has the best (longest) article title of the year in its piece about digital assets.

Dechert on ESG: An Overview for Asset Managers (Dechert)

Converting a Mutual Fund to an ETF: Key Considerations (Thompson Hine)

SEC and DOL Working Together on Retirement Advice Rules (Groom)

Private Equity and Venture Capital Investment in Opportunity Zones (Sadis)

Consecutive Private and Public Offerings for Registered Funds (Seward & Kissel)

Potential Regulatory Developments for Non-Traded Closed-End Funds (Drinker Biddle)

When It Comes to Analyzing Utility Tokens, the SEC Staff’s “Framework for ‘Investment Contract’ Analysis of Digital Assets” May Be the Emperor Without Clothes (Or, Sometimes an Orange Is Just an Orange) (Winston & Strawn)

New SEC Proposal May Complicate Proxy Voting & Engagement by Advisers (Stradley Ronon)

New Rules on Cross-Border Distribution of Investment Funds in the EU (K&L Gates)

The California Consumer Privacy Act: Key Points for Private Fund Managers (Schulte Roth & Zabel)

CFP Board’s New Standard of Conduct (Eversheds Sutherland)

SEC Finds Pervasive Regulatory Failures by Registered Funds and Boards

 

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has warned the registered fund industry about rampant regulatory violations involving compliance programs, disclosure, advisory contract approvals, and Codes of Ethics.  In a recent Risk Alert detailing common deficiencies and weaknesses uncovered during 300 examinations over the last two years, OCIE chided the industry for weak compliance programs including policies and procedures that failed to prevent violations of investment guidelines or to ensure fulsome disclosure in fund marketing materials; breakdowns in providing the Board with adequate fair valuation information and broker quotes; weak service provider and subadviser oversight; and inadequate annual reviews.  OCIE also criticized the information used to approve advisory contracts as well as shareholder disclosure in offering documents.  OCIE also warned that funds need to enhance their Codes of Ethics including reporting and how to define “access persons.”

Hire better service providers.  Not every lawyer knows the Investment Company Act Board approval, disclosure, and reporting rules.  Not every compliance person understands Rule 38a-1 and how to implement fund procedures and testing.  Not all administrator/distributors understand the differences between private funds and registered funds.  You wouldn’t hire a neurologist to perform surgery.  You shouldn’t hire just any lawyer or compliance consultant to implement your registered fund regulatory program. 

SEC Inspections Staff Chides Advisers for Weak Supervision and Compliance

The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert reporting significant compliance and supervision deficiencies.  Based on data collected from a 2017 sweep of over 50 advisers, OCIE found significant weaknesses in how firms hired, supervised, and disclosed information about employees with disciplinary histories.  The OCIE staff also cited frequent compliance deficiencies including failures to supervise how fees are charged, what marketing materials are distributed, and whether remote workers complied with firm policies.  OCIE also discovered that many advisers allocated compliance responsibilities but failed to assign those responsibilities or neglected to require documentation.  The OCIE staff recommends that advisers “reflect on their practices” and implement such best practices as enhanced hiring due diligence, background checks, heightened supervision, and remote-office monitoring.

 

How many times must OCIE warn the industry about compliance, and how many enforcement actions will it take, before firms implement a legitimate compliance program?  An investment adviser should spend at least 5% of revenue on compliance, hire a dedicated Chief Compliance Officer, adopt tailored policies and procedures, test the program every year, and prepare a written compliance report of deficiencies and remediation. 

Top 5 Regulatory Alerts – Q2 2019

Here are our Top 5 Regulatory Alerts for Q2 2019 (April-June), ranked by significance.  We have also included the Top 5 most read Alerts.

 

Top 5 Regulatory Alerts – Q2 2019

  1. SEC ADOPTS REGULATION BEST INTEREST, RAISING BROKER STANDARD OF CARE (6/6/19)
  2. SEC ALERTS RIAS/BDS TO CLOUD PROVIDER MONITORING OBLIGATIONS (5/24/19)
  3. SEC SAYS THAT ICO IS NOT A SECURITIES OFFERING (4/4/19)
  4. LARGE CUSTODY BANK TO PAY $89 MILLION FOR MARKING UP OUT-OF-POCKET EXPENSES (6/28/19)
  5. HEDGE FUND FINED $5 MILLION FOR WEAK VALUATION PROCEDURES (6/5/19)

 Most Read – Q2 2019

  1. ADVISER FACES INDUSTRY DEATH PENALTY AND CRIMINAL PROSECUTION FOR IGNORING CUSTODY RULE (4/1/19)
  2. BIG 4 FIRM FINED $50 MILLION FOR STEALING EXAM ANSWERS (6/18/19)
  3. CHIEF COMPLIANCE OFFICER STOLE EMPLOYEE INFORMATION TO BID AT AUCTIONS (6/4/19)
  4. DUAL-HAT PRINCIPAL/CCO CAUSED MULTIPLE COMPLIANCE VIOLATIONS (5/29/19)
  5. FRAT BRO RAN PONZI SCHEME (6/11/19)

Hedge Fund Fined $5 Million for Weak Valuation Procedures

The SEC fined a hedge fund $5 Million, and its Chief Investment Officer another $250,000, for failing to properly value portfolio securities. The SEC maintains that the firm over-relied on the discretion of traders to value Level 3 mortgage-backed securities rather than use required observable market inputs. The SEC contends that the firm consistently undervalued bonds to maximize profit upon sale. The SEC faults the CIO for failing to properly review valuation decisions and ensure that the traders followed the firm’s valuation procedures. The SEC asserts violations of the compliance rule (206(4)-7) because the firm failed to implement reasonable policies and procedures to ensure fair valuation of portfolio securities. As part of the settlement, the firm hired an experienced Chief Compliance Officer rather than rely on its prior Risk Committee comprised of executives with limited regulatory and valuation experience.

Valuation is about process. Firms that buy Level 3 securities must create a consistent, documented and contemporaneous process based on objective criteria in order to defend pricing decisions. For compli-pros, one way to test valuation is to sample whether liquidation prices vary consistently (either always higher or lower) than the firm’s internal valuations before liquidation.

SEC Official Warns Firms Not to Shortchange Compliance

In a recent speech, the Director of the Office of Compliance Inspections and Examinations, Peter Driscoll, admonished firms who do not adequately resource the compliance function. Calling compliance officers “partners,” Mr. Driscoll lauded their role on the “front lines” of regulatory compliance. Mr. Driscoll said that he could not “underscore enough a firm’s continued need to assess whether its compliance program has adequate resources to support its compliance function.” OCIE is concerned “when we hear directly from industry participants and read press reports that compliance resources and budgets are being cut or are not keeping up with firms’ risk profiles.” He stressed the importance of compliance as equal to other key business lines, critical to the success of the overall business in its role to protect the trust of clients, investors, and customers.

We have observed OCIE staff specifically ask about compliance resources and spending during examinations. Based on various research studies and our own empirical experience, firms should benchmark to spend at least 5% of revenue on compliance resources including personnel and technology. Of course, the actual spending should vary depending on the complexity and size of the business.