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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.

Private Equity Firm Mis-Allocated Expenses and Overlooked Conflicts

 A private equity manager agreed to pay over $2.8 Million in client reimbursements, disgorgement, penalties and interest in connection with mis-allocating overhead expenses and undisclosed conflicts of interest.  The SEC accuses the respondent of allocating a portion of staff expenses to the funds without disclosure or LP committee approval.   The respondent also failed to disclose that the principal had a financial interest in two consulting firms that did work for both the funds and the manager.  The SEC asserts that the firm failed to implement a reasonable compliance program, arguing that such a claim may rest on a finding of negligence.

This is low-hanging fruit for the SEC Enforcement Division.  When you get sloppy with expense allocations and ignore interlocking financial interests, the SEC can easily make its case that the firm acted negligently by failing to implement a sensible compliance program.

Direct Lending Platform Pays $5 Million to Settle Conflicts Charges

 

A direct lending platform agreed to pay a $4 Million fine and reimburse clients another $1 Million for allowing funds it managed to purchase loans in transactions that primarily benefited the parent company.  The SEC also barred and fined the firm’s CEO and fined the firm’s CFO.  The SEC asserts that the parent company used its controlling position on the Investment Policy Committee to force the funds to purchase loans outside its investment targets.  The SEC accuses the firm of using the buying funds as a liquidity source following the loss of two major institutional investors.  The SEC also maintains that the firm artificially inflated valuation and fund returns with undisclosed management adjustments.  The SEC did not charge the parent company because it self-reported and cooperated and engaged in significant remediation efforts including establishing a new independent governing board, outsourcing valuation, and retaining a third-party compliance consultant.

OUR TAKE: It is very difficult to cure the conflict of interest inherent in self-dealing transactions where an operating company depends on managed private funds for liquidity, and the funds source their assets only from the parent company.  This may be one of those conflicts that can’t be cured regardless of the disclosure.

Fund-of-Funds Manager Took Revenue-Sharing from Affiliates

The SEC fined a fund-of-funds manager $500,000 for failing to disclose that it received revenue sharing compensation from two affiliates that managed funds that the respondent recommended.  According to the SEC, the fund-of-funds manager negotiated side letters initially intended to benefit clients but which directly benefited the respondent through payments routed through the firms’ common parent domiciled in France.  The respondent failed to properly record the payments in its financials.  The SEC accuses the fund-of-funds manager with violating the specific terms of client agreements and failing to implement an adequate compliance program.

OUR TAKE: Inter-company payments among affiliates raise the same regulatory conflict of interest concerns as payments received from non-affiliates.  Compli-pros should follow the money to all of an adviser’s revenue sources in order to assess possible conflicts.  Also, non-U.S. entities, perhaps less sensitive to the Adviser’s Act’s requirements, should hire qualified lawyers or compli-pros to avoid tripping over the regulatory wires.

 

Large BD/IA Pays $2.2 Million for Recommending Wrong Mutual Fund Share Class

A large BD/IA agreed to pay $2.2 Million in remediation, interest and penalties for failing to recommend the lowest mutual fund share class available to retirement plan customers. Instead of recommending load-waived “A” shares, the respondent recommended other higher-cost share classes that resulted in compensation paid to the BD/IA.  The SEC faults the firm for failing to have adequate systems and controls in place to ensure that retirement clients benefitted from available discounts.   The SEC also asserts that the BD/IA omitted necessary disclosures about revenue sharing and the impact on overall investment returns.  An SEC Enforcement official warned that “these types of actions remains a priority for the Division” as evidenced by its recently-announced Share Class Selection Disclosure Initiative.

OUR TAKE: Firms must implement a system to ensure that eligible clients get the waivers to which they are entitled.  Compliance can’t rely on reps self-policing, especially when they receive higher compensation on certain share classes.

 

Adviser Borrowed From Clients without Full Disclosure of Financial Condition

The SEC censured and fined an investment adviser and its two principals for failing to disclose the firm’s weak financial condition to retail investors, including advisory clients, to whom it sold promissory notes.  As far back as 2012, the advisory firm struggled financially as its inability to raise assets and earn fees failed to offset rising operating costs. To keep afloat, the firm issued short-term promissory notes to retail investors including its advisory clients.  The SEC faults the firm for failing to disclose its weak financial position and the significant risk that it would not repay the notes (even though it did not default on any interest payment).  The SEC cites violations of the Exchange Act’s and Advisers Act’s antifraud rules.

OUR TAKE: The SEC can assert regulatory violations even where there is no client or investor harm.  Here, the SEC filed a settled enforcement action related to concerns about the notes even though the adviser never actually defaulted.  Adviser should also note that Item 18.B. of Form ADV requires disclosure of any “financial condition that is reasonably likely to impair your ability to meet contractual commitments to clients.”

https://www.sec.gov/litigation/admin/2018/33-10454.pdf

SEC Prosecutes De-Registered Adviser for Prior Compliance Failures

The SEC fined a deregistered investment adviser and barred its former principal for multiple compliance failures involving double dipping, Form ADV disclosures, fee rebates, and misrepresentations.  The respondents recommended that clients invest in private funds in which the principal held ownership and managerial interests.  Although the SEC acknowledges that clients knew about the conflict, the firm failed to list and describe the conflicts on Form ADV.  The SEC also charges the firm with multiple compliance program failures including inadequate policies and procedures and failing to conduct annual testing of the compliance program.

OUR TAKE: There is no such thing as declaring regulatory bankruptcy: the SEC’s long arm won’t let a firm engage in wrongdoing and then simply de-register to avoid consequences.    Compli-pros should also note that disclosure alone will not always cure significant conflicts of interest, such as fee double dipping for advisory services along with underlying products. 

https://www.sec.gov/litigation/admin/2018/ia-4836.pdf

Dual-Hat Principal/CCO Ignored SEC’s Compliance Deficiencies

The SEC has commenced enforcement proceedings against a fund manager and its principal/CCO for ignoring exam deficiencies about its compliance program and other violations.  The SEC examined the respondents in 2010 and 2014 and noted several compliance deficiencies, which the SEC asserts the respondents ignored.  The SEC charges the dual-hatted principal with failing to perform any work on the compliance program, adopting a stock manual that was not properly tailored to the business, or conducting any compliance review.  The SEC also faults the respondents for charging compliance costs to the funds.  The SEC additionally charges undisclosed conflicts of interest, misrepresentations, and valuation issues.

OUR TAKE: The SEC doesn’t always give you a second chance to fix cited deficiencies.  But when they do and you don’t, expect an enforcement action.  Also, this is another example of the failure of the dual-hatted CCO model, where an executive ignored his compliance responsibilities.  Penny wise and pound foolish.

 

SEC Prosecutes Unregistered Fund Manager for Over $1 Million

 

An unregistered investment adviser/fund manager and its principals agreed to pay over $1 Million in disgorgement, fines and interest for engaging in conflicted transactions that were not properly disclosed.  The SEC accuses the respondents of using fund assets to invest in a company that the principals controlled and then buying out the ownership interest at a loss, all without consent of the limited partners or any relevant disclosure.  The SEC also asserts that the respondents engaged in undocumented personal loans and payment of overhead expenses in contravention of the fund’s disclosure documents and limited partnership agreement.  Although the firm (which had less than $25 Million in AUM) was not registered, the SEC argues that it engaged in investment advisory activities, owed the fund and its investors a fiduciary duty, and, therefore, violated the Advisers Act’s anti-fraud rules.

OUR TAKE: Just because you are not eligible (or fail) to register as an investment adviser, does not mean that the Advisers Act does not apply.  In fact, most of the antifraud provisions apply to unregistered and state-registered advisers, thereby allowing the SEC to assert its enforcement jurisdiction.

 

Adviser’s Multiple Roles Allowed Misappropriation of Client Funds

The SEC commenced proceedings against an investment adviser who allegedly used his position as trustee and executor of his client’s estate and president and co-trustee of the client’s foundation, to misappropriate funds.  According to the SEC, the adviser befriended the elderly widow of a longtime client and convinced her to appoint him as her executor and foundation president.  After she died, he used his position to move money from her foundation to her estate checking account and then transferred funds to his personal accounts.  The SEC asserts that the adviser made more than 200 unauthorized transfers totaling more than $9 Million over a 12-year period.  The Manhattan District Attorney has also brought criminal charges.

OUR TAKE: Whether or not this particular adviser engaged in the alleged illegal activity, one key lesson is that an adviser should never assume multiple conflicting roles as investment adviser, executor of a client’s estate, and president of the foundation.  The appearance of impropriety alone would be hard to defend if an interested family member second-guesses any transaction.