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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 Proposes New Investment Adviser Advertising Rule

 

The SEC has proposed a new investment adviser advertising rule that broadens the definition of “advertising,” more specifically regulates performance information, and allows certain testimonials and endorsements.  Revised Rule 206(4)-1 would broadly include any communication distributed by any means that promotes advisory services or a pooled fund and prohibits any misleading or unsubstantiated statements.  The new rule would also require all retail-directed advertisements to include one, five and ten-year periods when presenting performance information.  Advisers would also be able to use testimonials so long as the adviser fully discloses whether the person is a client and whether compensation has been provided.  The new rule would also require approval in writing by a designated employee before dissemination.  The SEC said it may rescind current no-action letters.  The SEC also proposed a new solicitation rule that would require additional disclosure about the solicitor but eliminate the current rule’s requirement to collect client acknowledgements.  Both rules require at least a 60-day comment period.

We like that the SEC has modernized certain areas (e.g. testimonials) and has clarified how to present performance information.  We believe that clearer rules help compliance professionals and reduce the likelihood of enforcement cases resulting from subjective standards. 

SEC Warns Fund Industry about Inaccurate Performance and Fee Disclosures

 

The SEC Division of Investment Management’s Disclosure Review and Accounting Office has warned the fund industry to improve its fee and performance disclosure.  In its most recent release, the DRAO highlighted “several issues” including failures to verify the accuracy of performance and fee information.  In particular, the DRAO cites multiple funds that have failed to reflect the effect of sales loads in their average annual returns table, showing negative performance as positive performance, and transposing the performance of different fund classes and benchmarks.  The DRAO also faults fund-of-funds for failing to show the expenses of underlying acquired funds.  Funds also routinely make arithmetic errors and fail to properly use XBRL tags.  The DRAO “encourage[s] funds to closely review their performance and fee disclosures prior to providing them to investors.”

Over the years, many fund firms have delegated the preparation of registration statements to low-cost service providers that may not have the necessary knowledge, staffing and/or systems to prepare correct filings.  When hiring a vendor (administrator, lawyer, auditor), make sure that the firm has the experience and the resources to do your job right.  The cheapest is never the best and could cost you in the long run with a rescission or enforcement order.

Dual-Hat CCO and Partner Failed to Disclose Financial Interests to Clients

 

The SEC fined an investment adviser and its two principals, including its dual-hatted Chief Compliance Officer, for failing to disclose the principals’ financial interest in a recommended investment.  The two principals provided consulting services to a public company that they recommended to clients for investment.  The principals received common stock in the company as compensation and also bought stock directly.  The SEC alleges that neither the firm nor its principals disclosed their financial interests to clients who collectively owned 8.7% of the company.  The SEC also accuses the principals with misleading an outside compliance consultant by failing to respond to requests for information about any business in which the principals had a financial interest.

This case shows the importance of hiring a full-time, independent Chief Compliance Officer who can dispassionately review firm and principal transactions and implement necessary procedures and disclosures. The dual-hat model, where a firm principal or executive officer half-heartedly owns compliance, does not work in today’s regulatory environment where the SEC and institutional clients demand an independent and experienced compliance officer

SEC Fines Adviser for Paying Solicitors without Full Disclosure

 

The SEC censured and fined an investment adviser for paying solicitors without complying with the solicitation rule (206(4)-3).  The adviser had networking relationships with over 300 banks whereby the adviser paid the banks a substantial portion of the advisory fees received from clients referred to the adviser.  The SEC asserts that the adviser did not comply with the solicitation rule, which requires separate disclosure about the solicitation relationship, the specific terms, and the compensation received.  The adviser erroneously relied on a 1991 no-action letter, which stated that a bank need not register as investment adviser.  The no-action letter did not hold that bank solicitors were exempt from the solicitation rule.

We had predicted that the SEC would bring cases alleging violations of the solicitation rule.  The rule is intended to fully disclose the potential conflict of interest when a trusted adviser refers the client to an adviser that has provided a financial incentive.   A solicitor need not be registered as an adviser under state or federal law to come within the rule. 

SEC Wants Funds to Re-Work Principal Disclosure Risk in Summary Prospectuses

 

The SEC’s Division of Investment Management, through its Disclosure Review and Accounting Office, requests that mutual fund sponsors revamp the principal risk disclosure in the summary prospectuses.  The staff “strongly encourage[s]” funds to list principal risks in order of importance (rather than alphabetically) to better highlight risks that investors should consider.  Although the staff recognizes that this requires subjective judgment, the staff will not comment on a fund’s methodology.  The staff also recommends that funds tailor principal risk disclosure rather than utilize generic, standardized disclosure across funds, especially where different funds have differing investment objectives and policies.  The staff also reminds registrants to leave non-principal risks and other details to the Statement of Additional Information.

New registrants should expect the Disclosure staff to provide significant comments if they merely offer kitchen sink disclosure for principal risks.

SEC Proposes Changes to Public Company Disclosure Regime

 The SEC has proposed significant changes to the disclosure requirements for public companies, including how a registrant describes its business, its legal proceedings and risk factors.  When describing the business (Item 101), the proposal would move to a more principles-based disclosure regime focused on material information a registrant should disclose rather than a list of topics.  The new disclosures should also include a discussion of how the management of human resources affects the business.  The proposal also would require a narrative about the effect of government regulations on a company’s capital expenditures, earnings and competitive position.  There will be a 60-day comment period following publication.

It’s always good to focus disclosure on the material issues.  However, every SEC administration trumpets a goal of “improving disclosure.”  This effort may be like putting a coat of paint on a structurally defective house to prepare it for sale.  The issue for public companies is not how the lawyers should interpret Item 101, but the onerous compliance and regulatory obligations that may discourage private and non-U.S. companies from accessing the public markets. 

Federal Court Says that Outside Advice is Not a “Get-Out-of-Jail-Free Card”

The United States Court of Appeals for the D.C. Circuit upheld the SEC’s decision that an investment adviser failed to fully disclose mutual fund revenue sharing even if it sought and relied on the advice of outside compliance consultants. The Court found that the adviser acted negligently by failing to fully disclose the conflict of interest inherent by receiving shareholder servicing payments for investing in certain funds offered by its broker/custodian. Although the record was unclear about whether the adviser sought or relied on an outside compliance consultant’s advice, the Court decided that it didn’t matter because “any reliance on such advice was objectively unreasonable because [the adviser] knew of their fiduciary duty to fully and fairly disclose the potential conflict of interest.” The Court did, however, throw out the SEC’s claim that the adviser intentionally filed a misleading Form ADV, because the SEC failed to show that the adviser acted with the requisite intent to deceive.

As we have previously reported, this case argues in favor of seeking outside advice because it will help defend against the claim that you acted with intent, which would draw more punitive penalties. However, the Court here makes clear that relying on outside advice, even though you (should) know otherwise, will not exonerate you from claims that you acted negligently.

Adviser Failed to Disclose Personal Financial Problems

A state registered adviser was barred from the industry for failing to disclose a personal bankruptcy on Form ADV in addition to other charges. The Colorado Securities Commissioner cited a Form ADV that contained material omissions about the respondent’s 2017 personal bankruptcy and otherwise misrepresented his qualifications. The CSC also charged the respondent with overcharging clients and intentionally concealing the misconduct. The SEC also barred the adviser from the industry.

Form ADV, Item 18.B. specifically requires investment advisers to “disclose any financial condition that is reasonably likely to impair your ability to meet contractual commitments to clients.” Item 18.C. also requires the disclosure of any bankruptcy petition during the prior 10 years. As investment advisers struggle financially, compli-pros should assess whether the firm needs to enhance its financial condition disclosure.

Dual Registrant Lied Twice to Clients about Share Class Practices

A dually registered RIA/BD and two of its principals agreed to pay nearly $1.7 Million in disgorgement, interest and fines for recommending mutual fund share classes that paid back 12b-1 revenue sharing when lower cost shares were available.  The SEC faults the firm for failing to disclose that lower share classes were available, and that the firm and its reps made the recommendations to increase revenue rather than consider the best interests of the clients.  The SEC also criticizes the firm for neglecting to disclose that it avoided clearing broker ticket charges by recommending higher fee share classes.  After an SEC exam uncovered the wrongdoing, the firm embarked on a campaign to convert clients to lower-fee share classes, but, according to the SEC, many reps lied about the prior availability of lower-fee classes in a scheme to convince clients to pay higher advisory fees. 

Once the SEC identifies possible wrongdoing, don’t compound the problem by further misleading clients during the remediation process.  It is possible that this firm could have avoided the $400,000 in fines had it not lied to clients about its past practices.