The SEC has commenced proceedings against the principal of a venture capital fund manager for failing to properly register as an investment adviser under state law. The Connecticut securities regulator entered a final order alleging failure to register the fund manager as an investment adviser under Connecticut law and making false representations about the success of the funds. The action led to criminal proceedings to which the respondent entered guilty pleas. Now, the SEC has begun proceedings to implement federal civil penalties under the Advisers Act.
Avoiding required registration will not long go unnoticed. Eventually, the state securities regulators or the feds will find you. Your risk goes up exponentially if an aggrieved client has lost money or a competitor raises eyebrows.
The Massachusetts Securities Division has proposed a fiduciary rule for all brokers and advisers for the provision of recommendations, advice and selection of account type. The proposed rule would require that all recommendations and advice be made in the best interest of customers and clients without regard to the broker/adviser’s interests. The MSD asserts that the suitability standard has not sufficiently protected customers against sales contests, churning, risky products and bad brokers. The MSD also criticizes the SEC’s recently adopted Regulation Best Interest because it (i) does not fully protect investors; (ii) relies too much on disclosure; and (iii) does not resolve customer confusion about the applicable standard of care. The MSD is accepting comments until July 26.
The expansive MSD proposal includes any type of financial adviser, any type of customer, and any type of advice. If adopted, the MSD’s rule would set up a court case about whether Regulation Best Interest preempts state fiduciary rules.
The New York State Court of Appeals has ruled that the NYS Attorney General must institute cases under the Martin Act within a three-year statute of limitations period. The court reasoned that the Martin Act, a broad securities fraud statute, expands liability beyond common law fraud and does not permit private rights of action. Consequently, the shorter 3-year statute of limitations applies, rather than the default 6-year period requested by the Attorney General. The case involved Martin Act fraud allegations against the sponsor of residential mortgage-backed securities.
OUR TAKE: This decision follows recent Supreme Court cases limiting statutes of limitations in government enforcement proceedings. The case also materially constrains the use of the (over) broad Martin Act.
The New York State Attorney General has issued a report indicating that a record 1583 data breaches affecting 9.2 Million New Yorkers were reported to the NYAG in 2017. The information exposed included social security numbers (40%) and financial account information (33%). Hacking was the leading cause of the data security breaches. NYAG Eric Schneiderman warned “My office will continue to hold companies accountable for protecting the personal information they manage.” The NYAG has urged the New York State legislature to pass the SHIELD Act, which would require companies to adopt reasonable safeguards to protect sensitive data, including relevant policies and procedures.
OUR TAKE: The state regulators have taken a primary role in enforcing data protection safeguards. Make sure your compliance procedures have the necessary policies and procedures that include governance, incident response, vulnerability assessment, and vendor management.
The Massachusetts Securities Division instituted administrative proceedings against an unregistered fund manager for unlawfully charging a performance fee in addition to misleading investors. The MSD asserts that the respondent unlawfully “householded” an elderly client’s assets with a nephew with power of attorney in order to meet net worth thresholds required to charge a performance fee. Massachusetts law prohibits charging performance fees in violation of Rule 205-3 of the Advisers Act, which limits performance fees. In addition to other sanctions, the MSD seeks to prohibit the respondent from registering as an exempt reporting adviser.
OUR TAKE: Expect more cases like this where the state regulators take the enforcement lead. This is a rare case specifically alleging violations of the performance fee rule. Also, securities lawyers and compli-pros should take notice that (i) the Massachusetts statute makes it unlawful to violate an SEC rule that would otherwise apply only to SEC-registered advisers and (ii) the MSD seeks to prohibit federal exempt reporting adviser registration as a remedy.
The SEC fined and barred from the industry the principal of a purported private equity firm for looting one fund to pay another by inflating the valuation of an underlying security transferred between the funds. The SEC pleads that the defendant transferred a worthless interest in a start-up company to one of the funds and then had another fund buy that interest at a $2.8 Million valuation in order to pay off investors in the transferring fund. The SEC contends that the defendant failed to (i) properly value the security with third-party input, (ii) disclose the inherent conflicts of interest and (iii) comply with statements made in the offering memorandum. Neither the fund manager nor the principal were registered in any capacity, but the SEC was able to uncover the wrongdoing as a result of litigation brought by the Colorado Division of Securities.
OUR TAKE: The state securities regulators serve a valuable function ferreting out fraud and other wrongdoing by firms that fail to register with the SEC and might otherwise go undetected.
The Massachusetts Securities Division fined a large broker-dealer $1 Million for compensating financial advisers to encourage clients to open securities-based lending accounts at an affiliated private bank. The MSD asserts that the firm violated its own policies against sales contests and failed to quickly stop the program after Compliance raised objections. The MSD cites statistics showing significant growth in securities-based lending associated with the program. The MSD charges supervisory violations and failure to ensure “commercial honor and just and equitable principles of trade.”
OUR TAKE: The MSD could not assert a suitability violation because the securities-based lending accounts are not securities. Instead, the regulator employed the “equitable principles” catch-all doctrine, which looks very much like a fiduciary standard. Even if the DoL rule dies and the SEC refuses to move on a fiduciary standard, watch out for the state regulators.