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The BD/IA Regulator

Providing securities regulatory, enforcement and litigation trends for broker-dealers, investment advisers and investment funds

SEC Increases Net Worth Threshold for “Qualified Clients” under Rule 205-3 of the Advisers Act

Posted in Investment Adviser Regulation

On June 14, 2016, the SEC issued an order (the “Order”) to increase the net worth threshold for “qualified clients” under Rule 205-3 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), from $2 million to $2.1 million.  Rule 205-3 currently allows an investment adviser to charge a client (a “qualified client”) performance fees if:

  • the client has at least a certain dollar amount in assets under management (currently, $1,000,000) with the investment adviser immediately after entering into the advisory contract;
  • if the investment adviser reasonably believes, immediately prior to entering into the advisory contract, that the client either (A) had a net worth of more than a certain dollar amount (currently, $2,000,000) (the “net worth test”) or (B) is a “qualified purchaser” as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940, as amended, at the time the advisory contract is entered into; or
  • the client is (A) an executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser or (B) is a “knowledgeable employee” of the investor adviser.

The adjustment to the net worth threshold is being made pursuant to a five-year indexing adjustment required by Section 205(e) of the Advisers Act and Section 419 of the Dodd-Frank Act.  The effective date of the increase to the net worth threshold is August 15, 2016.  Qualified clients that enter into advisory contracts in reliance on the net worth test prior to the effective date will be “grandfathered” in under the prior net worth threshold.

A copy of the Order is available at: http://www.sec.gov/rules/other/2016/ia-4421.pdf

SEC Charges Private Fund Administrator with “Gatekeeper Failures”

Posted in SEC Enforcement

Add fund administrators to the list of service providers the SEC expects to act as “gatekeepers.” In two separate settled actions last week, the SEC found that a private fund administrator “caused” the managers’ unregistered private equity funds to violate the Investment Advisers Act.

According to the SEC, the administrator missed or ignored clear “red flag” indications of fraud while carrying out its responsibilities to keep records and prepare financial statements and investor account statements.

The SEC staff said that fund administrators are “responsible for ensuring that fund records provide accurate information about the value and existence of fund assets.” The staff found that the failure of the administrator in these cases to do so “essentially enabled the schemes to persist . . . until the SEC stepped in.”  The SEC found that the administrator’s failure to take action on the red flags presented by the managers’ actions was actionable, notwithstanding that fund administrators are not registered with the SEC.

The administrator agreed to the settlement without admitting or denying the charges and paid disgorgement, penalties, and interest of approximately $350,000.

Our take

It appears that it is not enough for policies and procedures to simply address the operational functions of administration contracts.  Administrators must ensure that they have implemented compliance and supervisory structures that provide a structure for raising concerns about client accounts.  Moreover, investment advisers should ensure that their due diligence processes question whether administrators have appropriate policies in place and understand how they work.

SEC Staff Throws Funds a Lifeline on Auditor Independence (For Now)

Posted in Fund Regulation, SEC Enforcement

The SEC’s Division of Investment Management provided temporary relief from the headache created for funds when the failure to meet the provisions of the so-called “loan rule” may disqualify fund auditors from being independent.

In a no-action letter issued to Fidelity Management and Research, the staff said it would not recommend enforcement action if a fund’s auditor fails to meet the independence requirements of Rule 2-01(b) of Regulation S-X because it has a lending relationship with an entity that owns (beneficially or of record) more than 10 percent of the fund’s equity securities (the “loan rule”).

But the relief is only temporary: the staff’s no action position expires in 18 months.

Under Regulation S-X, the SEC may not recognize an accountant as independent if the accountant is not, or a reasonable and knowledgeable investor concludes that they are not, capable of exercising objective and impartial judgment in the audit engagement.  Among other things, violation of the loan rule is a non-exclusive example of a circumstance that the SEC considers inconsistent with independence.

Several large fund managers recently created a kerfuffle when they disclosed that their funds’ auditors may not qualify as independent because they may have technically violated the loan rule.  These disclosures prompted funds and their independent auditors to scramble into action to stop a potential cascade of consequences, including calling into question the validity of fund audits and related pressure on fund audit committees.

What is the loan rule?  In relevant part, it states:  “An accountant is not independent when the accounting firm, any covered person in the firm, or any of his or her immediate family members has … [a]ny loan (including any margin loan) to or from an audit client, or an audit client’s officers, directors, or record or beneficial owners of more than ten percent of the audit client’s equity securities….”

Generally speaking, auditors maintain that simply having a lending relationship with a 10 percent owner of a fund client’s shares does not call into question their ability to be objective and fair in an audit engagement.  And, with appropriate disclosures, the funds’ audit committees can reach the same conclusion.

The SEC staff agreed, for the time being.  It said that it would not object if the funds rely on an audit opinion from an audit firm “that has identified a failure” to comply with the loan rule, provided three conditions have been satisfied:

  1. The audit firm has complied with PCAOB Rule 3526(b)(1), which provides, in substance, that the auditor must describe in writing any relationships between the auditor and the fund that may be reasonably be thought to bear on independence; and PCAOB Rule 3526(b)(2), which requires the auditor to discuss with the fund’s audit committee the potential effects of its relationships on its independence;
  2. The non-compliance of the auditor is with respect only to the lending relationships; and
  3. Notwithstanding non-compliance with the loan rule, the auditor has concluded that it is objective and impartial with respect to other issues encompassed within its engagement.

The staff clearly stated that the no-action assurances are temporary and expire in 18 months.

Can other fund groups rely on this no-action letter?  Although the letter was addressed to only one fund complex, it would appear that any fund group with similar facts may also rely on it.

Our take

The staff’s no-action position applies only to investment companies that file financial statements certified by auditors who may not be independent by virtue of the loan rule, and only for 18 months.  On its face, the relief does not extend to the auditors themselves.  In the short term, the letter provides a soft landing to a potentially explosive and intractable problem for funds.

With the threat of potential future non-compliance hanging over their heads, auditors and funds may be encouraged to find an alternative solution that does not require regulatory intervention by the SEC staff.  This will require some time – and creativity.

FINRA Sanctions Investment Firm Following Unsuitable Sales of Nontraditional ETFs

Posted in FINRA Enforcement

On June 7, 2016, FINRA settled proceedings against a New York-based investment firm for alleged violations of its suitability and related rules, namely NASD Rule 2310¹ and FINRA Rules 2111² and 2010.

According to FINRA, the firm allegedly failed to, among other things:

  • establish, maintain, and enforce a reasonably designed supervisory system and written supervisory procedures (WSPs) regarding nontraditional exchange-traded funds (ETFs); or
  • enforce its WSPs.

Without admitting or denying FINRA’s findings, and to settle the proceedings, the firm consented to a censure and a $2,250,000 fine, in addition to $716,831.80, plus interest, in restitution for certain of its customers.

Nontraditional or “alternative” ETFs, such as leveraged, inverse, and inverse-leveraged ETFs, utilize investment strategies that often entail returns and performance that can differ significantly from those of their underlying indices or benchmarks during the same period of time. In FINRA Regulatory Notice 09-31, FINRA advised broker-dealers and their representatives that nontraditional ETFs “typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.” FINRA has previously sanctioned broker-dealers in somewhat similar circumstances.


According to FINRA, from August 4, 2009 to September 30, 2013, the firm allegedly executed $1.7 billion of nontraditional ETF transactions in 30,740 retail brokerage accounts, with trading occurring in approximately 1,713 customer accounts serviced by more than 760 registered representatives. We note that the relevant period of the broker-dealer’s activity ended approximately three years ago; since that time, many market participants have tightened their practices and procedures as to complex products.

FINRA alleged that during this period, the firm failed to establish, maintain, and enforce a reasonably designed supervisory system or WSPs regarding the sales of nontraditional ETFs. FINRA also alleged that the firm allowed its representatives to recommend nontraditional ETFs:

  • without performing reasonable diligence to understand their risks and features; and
  • that were unsuitable for certain customers based on their age, investment objective, and financial situation.

Failure to Adequately Supervise

According to FINRA, the investment firm allegedly instituted WSPs that prohibited its representatives from soliciting retail customers to purchase nontraditional ETFs. For unsolicited purchases of nontraditional ETFs by retail purchasers, the WSPs allegedly required customer prequalification, which entailed: (1) liquid assets in excess of $500,000; (2) annual income of at least $200,000 ($300,000 combined spousal income) in the past two years; and (3) at least one year of experience trading in options.

Despite the WSPs, the investment firm, according to FINRA’s allegations, failed to enforce its requirements when it did not: (1) adequately train supervisors and registered representatives on these prohibitions; (2) prevent representatives from entering trades in the firm’s order-entry system; or (3) use an effective surveillance report to identify potentially problematic trades in violation of the firm’s policies.

According to FINRA, in certain instances, the firm allegedly allowed retail customers to make purchases of nontraditional ETFs, even though the relevant customers were not qualified — either because there was no prequalification letter on file or because the customer did not meet the prequalification criteria.

As we have pointed out from time-to-time, WSPs may be on target as to a particular rule or particular guidance from FINRA; however, following through consistently on these WSPs can be a challenge at times.

Unsuitable Nontraditional ETF Transactions

Certain alleged examples cited by FINRA include the purchase of nontraditional ETFs by an 89-year-old “conservative” customer with an annual income of $50,000 holding 96 solicited nontraditional ETF positions (for a net loss of $51,847), and the purchase by a 91-year-old “conservative” customer with an annual income of $30,000 holding 56 solicited nontraditional ETF positions (for a net loss of $11,161).

Based upon the alleged conduct, FINRA alleged that the firm violated NASD Rule 2310 and FINRA Rule 2111. In addition, FINRA alleged a violation of FINRA Rule 2010, which requires that FINRA members, in the conduct of their business, “observe high standards of commercial honor and just and equitable principles of trade.”


FINRA continues to review broker-dealer compliance with appropriate policies and procedures in connection with sales of complex products. Brokers should be considering both the adequacy of their WSPs as to these products, and whether they are following procedures that will ensure compliance with these WSPs.

¹Alleged violations of NASD Rule 2310 applied to conduct that occurred prior to being superseded by FINRA Rule 2111.

²Alleged violations of FINRA Rule 2111 applied to conduct that occurred on or after July 9, 2012.

Massachusetts Securities Division Searches for Rogue Brokers

Posted in Broker-Dealer Regulation, FINRA Enforcement

According to news reports, the Massachusetts Securities Division (the “Division”) recently sent a “sweep letter” to firms asking broker-dealers to report information about their hiring policies and procedures. The Division, led by Secretary of the Commonwealth William Galvin, sent this letter to firms in which more than 15% of their representatives have at least one current misconduct report on their records; this figure is said to be above the average for Massachusetts-registered broker-dealers.

These 241 brokerage firms were asked to disclose hiring information dating back to January 1, 2014. The Division seeks information about how many representatives were terminated or placed on heightened supervision since then, with the intention of “keeping the rogue broker out of the industry,” according to Mr. Galvin. The firms have a June 20, 2016 deadline to respond.

This review follows FINRA’s February 2016 issuance of its own sweep letter, requesting information about member firms’ compliance culture (see our blog post for more information). On May 23, 2016, FINRA’s chairman and CEO, Richard Ketchum, delivered a speech about firm culture and the importance of reviewing representatives and their disciplinary records, including prior to their hiring. FINRA’s focus on the securities industry culture aims to protect investors and market integrity through heightened scrutiny of broker-dealers, and state regulators like the Division have also taken increased market regulatory measures. In 2012, for example, the Division regulated structured product sales, imposing fines on a broker-dealer for sales of non-traditional ETFs.

FINRA Proposes Initial Round of Amendments to Communications Rules

Posted in Broker-Dealer Regulation, FINRA Enforcement, Investment Adviser Regulation

In May 2016, FINRA filed with the SEC proposed revisions to its communications rules that include a few substantive revisions to existing rules, ease some burdensome filing requirements, and leave the door open for future changes. The rules to be revised include:

  • FINRA Rule 2210 (Communications with the Public);
  • FINRA Rule 2214 (Requirements for the Use of Investment Analysis Tools); and
  • the content and disclosure requirements in FINRA Rule 2213 (Requirements for the Use of Bond Mutual Fund Volatility Ratings).

Read our client alert.

MJW to FSOC:  We’re On It

Posted in Broker-Dealer Regulation, Cybersecurity/Privacy, Fund Regulation

In a keynote address before the Investment Company Institute on May 20, 2016, SEC Chair Mary Jo White signaled to the Financial Stability Oversight Council (FSOC) that the SEC is “working hard” to finalize rules that address potential systemic risks in asset management.

The reminder follows FSOC’s recent statements that it continues to focus on systemic risks in certain asset management products, and in advance of an anticipated statement by the Financial Stability Board (FSB) on the same topic.  Chair White noted that the SEC is finalizing proposed rules on fund reporting, liquidity risk management and fund use of derivatives, which, among other things, are issues that FSOC and the FSB have publicly raised.

In what may be a subtle jab at the banking regulators, Chair White said the SEC advocates for “dynamic and robust regulation” that will meet all of the current and future risks and challenges, “while preserving the features that have served investors so well for more than seven decades.”  Fostering dynamic regulation for asset management, she said, has been one of the “critical responsibilities of the SEC since 1940.”

In addition to summarizing the SEC’s recent regulatory initiatives, Chair White provided a peek at future regulatory initiatives.

We can expect the SEC to tackle disclosure issues and technology challenges (especially cybersecurity) soon.  But, Chair White said, events over the past 10 years have “sharpened our focus” on particular types of funds that “require our enhanced attention.”

ETFs.  Specifically, Chair White identified exchange-traded funds (ETFs) as a target of enhanced regulatory attention.  In light of recent market volatility, the 2010 “flash crash,” and lackluster liquidity, among other events, the SEC’s staff is now “looking closely at the interconnectedness of the prices of ETF shares and their portfolio holdings and the impact on investors when the ETF’s mechanism does not function efficiently.”  The SEC staff is also focusing on how broker-dealers sell ETFs, and how investors understand these practices.

Disclosure.  Chair White announced a “disclosure effectiveness initiative” to address fund performance disclosures.  She said that the SEC’s staff will determine whether any improvements to disclosure requirements can be improved, and whether all information contained in a prospectus and statement of additional information (SAI) is necessary or helpful to investors.

Technology.  Chair White said that cybersecurity poses one of the greatest challenges facing the fund industry, and that the SEC will continue to draw attention to this issue.  She said that the SEC is also focused on technology disruptions that can affect pricing.

Portfolio pricing.  Chair White emphasized that portfolio valuation continues to be an SEC priority, and that the SEC and investors expect that funds price their portfolio holdings and shares accurately; Chair White said that she, along with fund investors, expect funds to “get it right.”

Our Take
In our view, a significant takeaway is that the SEC has subtly reminded the federal banking regulators that it is aware of their concerns about systemic risk in asset management and that the SEC, as the primary securities regulator, will deal with it.  This statement should reassure skittish markets that fear attempts by the banking regulators to assert jurisdiction over the asset management universe.

We note also that the SEC has identified ETFs as a prime focus.  We expect to see more to come in this area.