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The BD/IA Regulator

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

SEC Sanctions Adviser, Executives and CCO for Custody Rule Violation – Again

Posted in Investment Adviser Regulation, SEC Enforcement

On November 19, 2015, the SEC sanctioned a registered investment adviser, its two owners, and a former chief compliance officer for violating the Advisers Act “custody rule” after previously settling similar charges and agreeing to “cease and desist” from future violations.  Without admitting or denying the charges, the executives consented to the SEC’s findings that they caused and willfully aided and abetted the violations.

The former CCO agreed to pay a $60,000 penalty; two principals of the adviser agreed to a $1 million penalty and a one-year ban from raising money from new or existing investors.

The custody rule is designed to protect investor assets.  Among other things, the rule requires an adviser that has “custody” of client assets to ensure that the custodian sends quarterly account statements to clients and that an independent public accountant verifies the assets in client accounts each year.  Advisers of pooled investment vehicles (“funds”) that send investors audited financial statements within 120 days of a fund’s fiscal year-end, however, are not required to obtain independent verification of portfolio assets or to satisfy the quarterly account statements delivery requirement.

The SEC found that, for three fiscal years beginning in 2010, the adviser and its executives failed to timely distribute audited financial statements to investors in pooled investment vehicles managed by the adviser.  This alleged failure violated Rule 206(4)-2, the so-called “custody rule” under the Advisers Act.  Moreover, the SEC found, the advisers and the executives violated the cease and desist order relating to the previous violations.

The SEC found that, notwithstanding the prior settlement order, the adviser and its principals took no remedial action to ensure compliance with the custody rule.  Moreover, the SEC found that the former CCO substantially assisted the adviser’s violations of the custody rule.

The SEC said that although the adviser’s compliance manual tasked the CCO with ensuring compliance with the custody rule, the CCO did not implement necessary policies or procedures to ensure such compliance.  The SEC found that the former CCO “simply reminded people of the custody rule deadline without taking any more substantial action.”  The SEC also criticized the former CCO for failing to notify the SEC staff of the adviser’s difficulties in meeting the custody rule deadlines.

The SEC suspended the CCO from serving as a chief compliance officer for one year.

Our take.  This settlement comes after a series of speeches by SEC officials that it was not targeting CCOs or second-guessing them.  The order provides an example of the threshold of undesirable behavior that a CCO must cross to spur an enforcement proceeding.  To be sure, in light of the SEC’s public statements related to their concerns about recidivism, a repeat offense will likely catch the enforcement division’s eye.

Compliance Reporter December Breakfast Briefing

Posted in Events

The Compliance Reporter’s December Breakfast Briefing will take place on Wednesday, December 2nd in New York, New York. The event will be held at The Lambs Club and will be centered on offering the latest practical advice for chief compliance officers at broker/dealers and investment managers on avoiding the pitfalls and keeping your firm safe. Partner Anna Pinedo will be a panelist on the session “Social and CCOs: The Latest in Tackling a Thorny Issue”.

Potential topics for discussion include:

  • What are the key risks in using social media?
  • How can you let employees market without creating liabilities?
  • What are the most effective social media policies?
  • How can you best present your firm’s social media approach in an exam?
  • What’s next from the regulators?

For more information about this event, click here.

SEC Agenda for 2016: Tighten Rules on Leverage for Funds; Stress Testing and Third-Party Compliance Reviews for Advisers

Posted in Fund Regulation, Investment Adviser Regulation

In testimony before the House Committee on Financial Services on November 18, 2015, SEC Chair Mary Jo White described what the SEC has in store for the investment management industry.

Chair White said that, in addition to recent rule proposals concerning liquidity risk management and disclosure enhancements, the SEC staff is working on additional initiatives “aimed at helping to ensure that the Commission’s regulatory program is fully addressing the increasingly complex portfolio composition and operations of the asset management industry.”  These initiatives include:

  • Use of Derivatives by Investment Companies. SEC staff is working on a recommendation that the Commission propose new requirements related to the use of derivatives by registered funds, including measures to appropriately limit the leverage these instruments may create, and to enhance risk management programs for such activities.
  • Transition Plans for Investment Advisers. Staff is also developing recommendations that the Commission propose requiring investment advisers registered with the Commission to create and maintain transition plans to prepare for a major disruption in their business.
  • Stress Testing for Large Investment Advisers and Large Investment Companies. Staff is also considering recommending that the Commission propose new requirements for stress testing by large investment advisers and large investment companies. Such rules would implement, in part, requirements under section 165(i) of the Dodd-Frank Act.
  • Third-Party Compliance Reviews. At the Chair’s direction, the staff is also preparing a recommendation to the Commission for proposed rules that would mandate third-party compliance reviews for registered investment advisers. The reviews would not replace examinations conducted by the SEC’s Office of Compliance Inspections and Examinations, but would be designed to improve overall compliance by registered investment advisers.

Our take.  These initiatives indicate that the SEC, carefully watching the Financial Stability Oversight Council in its rearview mirror, continues to focus on assessing and monitoring systemic risk.  These initiatives may limit current fund practices and strategies and increase compliance costs.

SEC Sanctions Adviser for Misstatements in Advertisements, Client Presentations and Regulatory Filings

Posted in Investment Adviser Regulation, SEC Enforcement

The SEC found that a registered investment adviser that operates as a “manager of managers” misstated a sub-adviser’s investment performance in communications with its clients, potential clients and the SEC.  According to the SEC, these misstatements occurred despite warnings from FINRA that the use of back-tested investment performance in mutual fund advertisements was misleading and concerns about the sub-adviser’s track record that were raised by other market participants.

The SEC found that the adviser published the inflated, hypothetical and back-tested performance record of a sub-adviser in regulatory filings, mutual fund advertisements and client presentations over a period of more than four years.

The SEC also found that the adviser failed to adopt and implement written compliance policies reasonably designed to prevent violations of the Advisers Act and related rules.  In particular, although the adviser’s policies addressed its obligations with respect to advertising performance of its client accounts, those policies did not address the accuracy of third-party-produced performance information or third-party marketing materials or provide a means of reporting and assessing concerns raised about the accuracy of statements in such marketing materials.

Notably, these issues arose although the adviser initially “expressed skepticism” about the      sub-adviser’s track record.  The SEC said that the adviser continued to refer to the incorrect numbers despite several red flags.  For example, the adviser allegedly was aware of warnings from other market participants to the adviser’s wholesalers that the track record reflected back-tested results rather than performance of “live” assets.  A data provider that attempted to recreate the advertised track record also raised concerns.  The SEC found that, although the adviser raised questions with the sub-adviser about these concerns, it failed to follow up on its own questions.

The adviser retained an independent compliance consultant to review its compliance policies and procedures and settled the SEC’s charges without admitting or denying the findings.  The adviser must disgorge fees of $13.4 million plus prejudgment interest of $1.1 million and incurred a civil money penalty of $2 million.

Our take.  The SEC recognized that the adviser asked questions of the sub-adviser and its principal and, in certain instances, was misled.  This, together with a decision to proactively retain a compliance consultant, probably helped to reduce the firm’s penalty.  Nevertheless, the adviser’s failure to adequately follow up on its concerns – and to implement a compliance program tailored to its business as a manager of managers – resulted in a failure of its compliance infrastructure that the SEC found actionable.  Advisers need to ensure that their compliance programs provide adequate oversight of service providers – including sub-advisers – and that the compliance program includes a means of verifying that concerns about compliance matters are raised and addressed appropriately.

For an additional discussion of recent SEC sanctions imposed on an adviser for material misstatements in advertisements and misrepresentation of investment performances, see our recent blog post.

ICI Survey: Mutual Fund Independent Directors Are Getting Older and Wiser

Posted in Fund Independent Directors

Mutual fund directors are getting older and wiser as they oversee a growing amount of assets and number of funds, according to a governance study published by the Investment Company Institute on October 27, 2015.

The ICI’s study, which tracks governance practices from 1994 to 2014, identified a number of trends that would not surprise many fund directors.

The report shows that average net assets overseen by independent fund directors increased to $116 billion, up from $7 billion in 1994.  Similarly, the average number of funds overseen by independent directors increased to 57 from 26 in 1994.

Independent directors are getting older, too.  The average age of independent directors increased to 66 from 62 over the past 20 years.  The percentage of fund groups that established mandatory retirement policies increased to 69 percent from 45 percent, while the mandatory retirement age for those boards crept up to 75 from 72.

The survey’s other key findings included, among other things:

  • The percentage of fund boards consisting of at least 75 percent of independent directors increased to 83 percent from 46 percent in 1994.
  • Nearly two-thirds of all fund boards have an independent chair.
  • The percentage of fund complexes reporting that independent legal counsel serve their independent directors increased to 92 percent from 64 percent in 1998.
  • 97 percent of fund boards have one or more audit committee financial experts.

Our take.  Mutual fund boards are getting older, busier and wiser.  It seems that this trend will continue as fund assets, the number of funds and the complexity of issues continue to grow.

OCIE Cautions Advisers About Outsourcing Compliance Activities

Posted in Fund Regulation, Investment Adviser Regulation, SEC Enforcement

In a Risk Alert dated November 9, 2015, the SEC’s Office of Compliance Inspections and Examinations (OCIE) said it found that outsourced compliance programs are generally effective, but some of these arrangements leave room for improvement.

As part of its Outsourced CCO Initiative, OCIE examined 20 registered advisers and funds (“registrants”) that outsource their compliance activities to assess the effectiveness of outsourced compliance programs and CCOs.  The Risk Alert summarized its findings.

While OCIE stopped short of criticizing outsourced compliance activities, it called attention to its concern that registrants should not be complacent with “off-the-shelf” compliance programs and monitoring.

Based on the results of the 20 examinations, OCIE observed that an effectively outsourced CCO generally involved:

  • Regular, often in-person, communications between CCOs and registrants (rather than, for example, reliance on pre-defined checklists);
  • Strong relationships established between CCOs and registrants;
  • Sufficient resources for the CCO, particularly in cases where a CCO serves in that capacity for multiple unaffiliated firms;
  • Sufficient, independent CCO access to documents and information necessary to conduct annual reviews; and
  • CCO knowledge about regulatory requirements and the registrant’s business.

OCIE said that “an effective compliance program generally relies upon, among other things, the correct identification of a registrant’s risks in light of its business, operations, conflicts and other compliance factors.”  OCIE cited examples of certain outsourced CCOs who “could not articulate the business or compliance risks” of a registrant or, to the extent the risks were identified, whether the registrant “had adopted written policies and procedures to mitigate or address those risks.”  OCIE discouraged use of standardized compliance checklists, which sometimes do not address risks specific to particular registrants.  In addition, the examiners found that in some instances:

  • registrants “did not appear to have the policies, procedures, or disclosures in place necessary to address all of the conflicts of interest identified” by the examiners;
  • compliance policies and procedures were not followed or actual practices diverged from the procedures in the compliance manual in some critical areas (e.g., personal trading and payment for solicitation activities);
  • off-the-shelf compliance policies and procedures were not tailored to a registrant’s actual business practices; and
  • there was a “general lack of documentation evidencing the testing” of compliance procedures.

Our take.  OCIE is focused on compliance officers and their responsibilities, and wants to ensure that CCOs are effective and receive adequate support.  OCIE published the risk alert shortly after the SEC announced it settled enforcement charges against certain CCOs.  In addition, in the face of allegations that the SEC was unfairly targeting CCOs, SEC officials publicly reassured compliance officers that this was not the case.  This alert is a gentler way for the SEC to convey its message that registrants that outsource compliance activities are still responsible for ensuring that the CCO is doing its job and that compliance programs are regularly tested and effective.

FINRA Proposes Rules to Help Avoid Financial Exploitation of Seniors

Posted in FINRA Enforcement

Avoiding financial exploitation of older investors has been on our regulators’ radar screens for several years. With new rules proposed in October 2015, FINRA seeks to make investing safer for seniors and other vulnerable adults.

The proposed new rules would permit (but not require) a broker to place a temporary hold on a disbursement of funds or securities from customer accounts. They would also require brokers to obtain for each non-institutional account holder the name of a “trusted contact person,” so that the trusted contract person could be reached if a hold is imposed.

The proposed rules may be found at the following link: http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-15-37.pdf

Who Do the Proposed Rules Protect?

New proposed Rule 2165 would create a new category of persons: “specified adults.” A specified adult would be defined as someone who is:

  • any natural person age 65 or older (regardless of their perceived mental or physical health); or
  • a person 18 or older that is reasonably believed by the FINRA member to have a mental or physical impairment that renders the person unable to protect his or her own interest.

Financial Exploitation

What are the proposed rules designed to address? As defined by FINRA, “financial exploitation” would include:

  • the wrongful or unauthorized taking, withholding, appropriation, or use of a “specified adult’s” funds or securities; or
  • any act or omission taken by a person regarding a specified adult:
    –  to obtain control through deception, intimidation or undue influence over the specified adult’s money, assets or property; or
    –  to convert the specified adult’s money, assets or property.

Placing a Hold on an Account

Proposed new Rule 2165 would permit, but would not require, a “qualified person” at the firm with a “reasonable belief” that financial exploitation is occurring to place a hold on the account of a specified adult customer. The hold could also be imposed if the financial exploitation is believed to have previously occurred, has been attempted, or will be attempted in the future.

The “qualified person” would be an associated person of a firm serving in a supervisory, compliance, or legal capacity that is reasonably related to the account of the specified adult.

When exercising discretion under Rule 2165, the firm would be required to notify all authorized parties on the account, and in most instances, the trusted contact person, within two business days after placing the hold. If the trusted contact person is believed to be engaged in the financial exploitation (not a pleasant set of facts to contemplate, unfortunately), then the firm must contact an immediate family member of the specified adult (unless that person is also believed to be engaged in the financial exploitation).

A firm placing a hold on a customer’s account must also immediately initiate an internal review of the facts and circumstances that caused the qualified person to reasonably believe that there is, was or will be financial exploitation.

The hold would expire not later than 15 business days from the date of the hold and, if supported by the facts and circumstances upon an internal review, may be extended for another 15 business days. The hold may expire after the designated number of business days, or it may be terminated or extended by a court of competent jurisdiction.

Finding a Trusted Contact Person

Rule 4512, relating to customer account information, would be revised to require firms to make a reasonable effort to obtain the information of a trusted contact person for all non-institutional customer accounts. (The “reasonable effort” standard may be satisfied by simply asking the customer.) If a customer does not provide this information notwithstanding the broker’s reasonable efforts, the account could still be opened and maintained.

For existing accounts, a firm would only need to attempt to obtain the contact information at such time as it updates the account information, either in the course of the firm’s ordinary business, or as otherwise required by law.

The trusted contact person must be at least 18 years old, and must not be authorized to transaction business on behalf of the account.

What May Be Disclosed to a Trusted Contact Person

The types of information that could be disclosed by the firm to the trusted contact person include the relevant customer’s current contact information, health status, and identity of any legal guardian, executor trustee, or holder of a power of attorney. Under proposed Rule 2165, the trusted contact person could also be notified of a temporary hold on disbursements of funds or securities.

Administration, Supervision and Training

Under the proposed rules, firms would be required to update their disclosures for new accounts, so as to indicate the types of information that may be disclosed to a trusted contact person. Firms will also be required to maintain records relating to their compliance with the new rules, including their findings that financial exploitation may be occurring.

Firms will also be required to establish supervisory procedures to achieve compliance with the rules. The procedures must include the identification, escalation and reporting of financial exploitation. Firms will also need to develop training policies or programs to ensure compliance with the rules.

More About the Safe Harbor and Imposing a Hold

The permitted hold is a “safe harbor” provision. A hold need not be imposed; however, firms that do so in accordance with the new proposed rules would be in compliance with FINRA’s rules. (In contrast, obtaining the account information about trusted contact persons would be required in all cases.)

Accordingly, the proposed rules place an interesting choice on firms: if they do impose a hold, it is possible that the hold could be challenged by the accountholder, which could generate questions as to whether the firm fully complied with the requirements. For example, did the firm have a reasonable basis to believe that exploitation was occurring? Was the finding appropriately escalated? Did the firm have appropriate policies and procedures? Was the firm timely in making its required notifications? Ironically, especially in cases that aren’t so clear-cut, a firm may find the safer course to be not to impose a hold. However, for those firms that are prepared to go the extra mile to help their vulnerable accountholders, the proposals would provide a basis and a safe harbor for doing so.