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Barred Adviser Lied to Investors about Track Record, Credentials and Performance

 

The SEC has commenced proceedings against a barred investment adviser for fraudulent statements made during a note offering.  The SEC alleges that the respondents concealed a barred adviser’s disciplinary history and industry bars by entering into a bogus operating agreement showing a 5% ownership interest when he had a 50% stake.  The other partner to the venture had little to no securities experience.  The SEC accuses the respondents of lying to investors to induce them to purchase promissory notes with their self-directed IRA accounts.  The respondents allegedly lied about performance, safety, track record, and credentials.

This is exactly why the industry needs an active regulator.  Only by ridding the industry of (alleged) liars and thieves like this can the investment industry instill confidence in the regulators, the clients, and the lawmakers.  Ultimately, strong regulation facilitates growth as evidenced by the $20 Trillion in assets in registered funds and ETFs, the most regulated investment products on the planet. 

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)

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)

The Friday List: 10 Things We Learned During the Fall 2019 Investment Management Conferences

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 we approach the end of the year, we can reflect on what we learned at the panoply of investment management conferences we attended since June.  CCS professionals attended most of the major industry conferences and compared notes.  As we talked, we concluded that some of the same themes arose from the conferences’ agendas and speakers.  We thought our clients and friends might benefit from our meta-observations.

10 Things We Learned During the Fall 2019 Investment Management Conferences

  1. Proxy Voting. Nobody is exactly sure how to supervise proxy voting firms.
  2. Cybersecurity. The authorities are warning about targeted cybersecurity attacks, not just generalized cyber threats.
  3. RIA Advertising. Everybody likes the new RIA advertising rule, but many are concerned about heightened enforcement.
  4. Expense Transparency. The Investment Management Division is focused on fee and expense transparency especially as advertised fund expenses approach zero.
  5. Portfolio Management. OCIE will investigate whether portfolio management practices deviate from disclosures made to clients and investors.
  6. Custody. Private fund firms still do not comply with the custody rule either because they fail to delivery financials on time or because they fail to engage a PCAOB firm.
  7. Form CRS. Everybody is trying to make Form CRS as marketing-friendly as possible while including all required information.
  8. AML. There is over-reliance on clearing firms to perform anti-money laundering surveillance.
  9. Technology. Technology firms are selling a variety of solutions to automate advisers’ back and middle offices.
  10. ETFs. Industry players expect a proliferation of active ETF products in the wake of the proposed rule.

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. 

Exempt Reporting Adviser Barred and Fined Over $1.1 Million

The principal of an exempt reporting adviser was barred from the industry and agreed to pay over $1.1 Million in disgorgement and penalties for conflicted transactions and misrepresentations.  The SEC charges that the respondent caused a fund he managed to purchase a portfolio company from an affiliated fund in violation of the purchasing fund’s debt and concentration limits.  The SEC asserts that the respondent intentionally misled investors by undervaluing the portfolio company in financial statements and disclosure documents.  The SEC also claims that the respondent misled investors about underlying investments and charging undisclosed monitoring fees.  The SEC also fined the firm’s CFO/CCO.  The SEC cites violations of the anti-fraud rules under the Advisers Act (206(4)-8), the Securities Act (17(a)(1) and 17(a)(3)), and the Exchange Act (10b-5).

An exempt reporting adviser is still subject to several provisions of the Advisers Act, including its fiduciary and anti-fraud rules.  We recommend that ERAs implement a legitimate compliance program to avoid a firm-ending regulatory action like this one.

Private Fund Manager Completely Shirked His Compliance Obligations

 

The SEC fined a now-defunct fund manager for ignoring its compliance obligations.  The SEC charges that the firm never delivered audited fund financials within 120 days as required by the custody rule (206(4)-2).  Although the firm did hire an auditor, the firm never received an opinion that the financials were prepared in accordance with GAAP.  Instead, the audit firm issued reports stating that it was unable to express such an opinion.  In addition, the SEC charges the firm with violating the compliance rule (206(4)-7) because the principal, who also served as the Chief Compliance Officer, failed to adopt and implement policies and procedures and disregarded his obligation to conduct annual compliance reviews.

When you register as an investment adviser, you subject yourself to the full panoply of substantive regulation imposed by the Investment Advisers Act.  To comply and continue as a going concern, you need to hire a competent Chief Compliance Officer to help you meet the regulatory requirements.  Otherwise, you may end up either in your next career or in jail.

SEC’s Blass Announces Plans to Modernize Adviser Marketing Rules

The SEC’s Investment Management Division Director, Dalia Blass, anticipates that the Division will soon recommend changes to the adviser marketing and solicitation rules.  In her annual speech to the Investment Company Institute membership, Ms. Blass also announced initiatives for a summary shareholder report, updates to the valuation guidance, modernization of the offering rules for business development companies and closed-end funds, and changes to the rules for funds’ use of derivatives.  Additionally, Ms. Blass wants the Division to finalize the proposed ETF and fund-of-funds rules.  She has also asked the staff to begin an outreach to small and mid-sized fund sponsors about regulatory barriers.  She announced that the Division is considering the formation of an asset management advisory committee to solicit diverse viewpoints on critical issues.

We applaud the reinvigorated Investment Management Division for tackling some of the thornier problems that have faced the industry for many years.  For instance, the marketing rules haven’t changed for decades despite revolutionary change in the financial services industry.