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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 Alt Fund Asset Manager for Fee Overcharges and Misleading Investors

Posted in Enforcement, Investment Adviser Regulation

On January 19, 2016, the SEC settled proceedings against a Denver-based asset manager for material misstatements made in the offer and sale of units of a publicly-registered managed futures fund.  The SEC found that the manager disclosed that it charged the fund management fees based on the net asset value of each of the fund’s series when, in fact, the management fees were calculated based on the notional trading value (including leverage) of the assets in each series.

The manager is registered as an investment adviser with the SEC and as a commodity pool operator with the Commodities Futures Trading Commission.  The SEC’s jurisdiction over the manager primarily stems from its registration as an investment adviser, although it was also found to have caused the fund to violate its reporting obligations (under the Securities Exchange Act of 1934) related to the fund’s securities registered under the Securities Act of 1933.  The fund is a commodity pool and is not a registered fund under the Investment Company Act of 1940.

According to the SEC, the adviser calculated its management fees in a manner inconsistent with the method described in the fund’s registration statements and periodic reports.  It also deviated from the disclosed valuation methodology for some of the fund’s holdings.

The SEC found that the adviser engaged in the following disclosure violations on behalf of the fund:

  • The fund’s registration statements disclosed that the adviser charged management fees based upon the net asset value (NAV) of each series.  However from 2004 to 2011, the adviser actually used the notional trading value of the assets (i.e., the total amount invested including leverage).  This resulted in a $5.4 million overcharge to the fund by the adviser.
  • The fund’s 2010 Form 10-K and 2011 Q1 and Q2 Forms 10-Q disclosed that its methodology of valuing certain derivatives was “corroborated by weekly counterparty settlement values.”  According to the SEC, however, the adviser received information during that timeframe showing that its valuation of certain options was materially higher than the counterparty’s valuations.
  • The fund’s 2011 Q3 Form 10-Q disclosed that an option had been transferred between two series consistent with the fund’s valuation policies.  According to the SEC, however, the option was actually transferred using a different valuation methodology than substantially identical options held by other series.
  • The fund’s 2011 Q2 Form 10-Q failed to disclose, as a material subsequent event, the series’ early termination of an option that constituted its largest investment at a materially lower valuation than had been recorded for that option.

To settle the proceedings, the adviser agreed to refund investors approximately $5.4 million in excessive fees collected, plus $600,000 in prejudgment interest accrued.  In addition, the adviser agreed to pay a $400,000 civil penalty.

Our Take
This case reinforces the need to ensure that funds carefully review their disclosure documents and ensure that internal policies and procedures are consistent with their stated disclosure.  In addition, and as we noted in our post about OCIE’s 2016 priorities, although OCIE dropped its explicit focus on alternative investment companies from this year’s priorities list, it would be prudent to assume that OCIE will continue to focus on alternative funds, especially in light of the recent rule proposal on funds’ use of derivatives.

The Role of the CFTC in the Market

Posted in Events

On Thursday, February 4, The George Washington University’s Center for Law, Economics, and Finance will hold a symposium entitled “The 2016 Manuel F. Cohen Lecture: The Role of the U.S. Commodity Futures Trading Commission (CFTC) in the Market.”

The CFTC is a pivotal federal regulatory body that protects the public from fraud, manipulation, and abusive practices related to derivatives and other products that are subject to the Commodity Exchange Act.

Partner Anna Pinedo will speak on a panel regarding key concerns surrounding systemic risk related to the instruments and entities impacted by the CFTC.

For more information or to register, please click here.

OCIE Publishes Exam Priorities for 2016

Posted in Broker-Dealer Regulation, Investment Adviser Regulation

The National Exam Program of the SEC’s Office of Compliance Inspections and Examinations (OCIE) published its examination priorities for 2016 this week.  (FINRA published its priorities last week, discussed here.)  Much like last year’s letter, this year’s letter is organized around three key thematic areas of focus:

Protecting Retail Investors—Including Those Saving for Retirement.
As in 2015, OCIE will focus attention on retail investors, specifically those saving for retirement.  OCIE identified several areas of particular interest and specific initiatives, including:

  • The ReTIRE multi-year examination initiative, originally announced in June 2015, which focuses on the services offered by registered investment advisers and broker-dealers to investors with retirement accounts.  The initiative evaluates, among other things, whether recommendations made to investors have a reasonable basis, conflicts of interest, supervision and compliance controls.
  • Exchange-traded funds (“ETFs”) and compliance with regulatory requirements, in addition to reviewing creation/redemption processes, sales strategies, trading practices and disclosure of concentration, primary and secondary market trading risk and suitability of leveraged/inverse ETFs.
  • Regulated entities’ supervision of registered representatives and investment advisers in branch offices.
  • Varying fee arrangements offered to retail investors by investment advisers and dually registered investment adviser/broker-dealers and recommendations of account types, both initially and throughout the relationship, including fees charged, services provided and disclosures made about such arrangements.  This includes last year’s focus on reverse churning concerns.
  • Suitability of sales of variable annuities products to investors, adequacy of disclosure and supervision of such sales.
  • Advisers to municipalities and government entities focusing on pay-to-play (also, see our post here) and certain other key risk areas related to advisers to public pensions, including gifts and entertainment.

Market-Wide Risks.
In order to maintain fair, orderly and efficient markets, OCIE will examine structural risks and trends that involve multiple firms or entire industries, including, among others:

  • Broker-dealers’ and investment advisers’ cybersecurity compliance and controls, including testing and assessments of firms’ implementation of procedures and controls.
  • Systems compliance and integrity (“SCI”) entities to evaluate the establishment, maintenance and enforcement of policies and procedures.
  • Advisers to mutual funds, ETFs and private funds and their liquidity controls and procedures, including registered broker-dealers that have become new or expanding liquidity providers in the marketplace.

Using Data Analytics to Identify Signals of Potential Illegal Activity.
Much like 2015, OCIE intends to continue to develop and use its enhanced data analytics to identify firms that appear to be engaged in fraudulent or other illegal activity.  OCIE will:

  • Continue to use its analytical capabilities to identify those firms that hire individuals with a record of misconduct.  Firms should review their own hiring records to determine if they are likely to draw OCIE’s attention.
  • Examine clearing and introducing broker-dealers’ anti-money laundering programs to focus on firms that have not filed the number of suspicious activity reports (“SARs”) that would be consistent with their business models or have filed incomplete or late SARs.
  • Use its data to examine operations of broker-dealers and transfer agents to uncover incidences of market manipulation.
  • Use its data from clearing firms to identify brokers that are engaged in excessive trading.
  • Continue to focus on detecting the promotion of new, complex and high-risk products and related sales practices for suitability or potential breaches of fiduciary obligations.

In addition to the themes described above, OCIE expects to examine:

  • Newly registered municipal advisers to assess compliance with the recently adopted SEC and Municipal Securities Rulemaking Board rules.
  • Private placements (including Regulation D and EB-5 Program offerings) for due diligence, disclosure and suitability legal requirements.  Changes to relevant U.S. securities regulation offer a variety of new distribution possibilities; regulators have expressed some interest in determining whether these privately placed securities are being sold properly.
  • Never-before-examined investment advisers and investment companies.
  • Private fund advisers, with a focus on fees and expenses and the controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts.
  • Transfer agents’ safeguarding of security-holder funds, among others.

Our Take
As we noted last year when we reviewed OCIE’s examination priorities, little about the 2016 priorities should come as a surprise.  We note, however, that OCIE’s published list is not exhaustive.  Although OCIE dropped its explicit focus on alternative investment companies, it would be prudent to assume that OCIE will continue to focus on them, especially in light of the proposed rules for liquidity management and derivatives.  We also note that OCIE added variable annuities, pay-to-play and gifts and entertainment, among other issues, to its list of priorities, which may indicate a subtle shift to a more refined emphasis on conflicts of interest.

FINRA Releases Proposed Rule to Reduce the Regulatory Burdens on Boutique Investment Banks

Posted in Broker-Dealer Regulation

FINRA has filed with the SEC a proposed rule which would reduce the regulatory burden for broker-dealers that limit their activities to M&A and certain corporate financing transactions.  The proposed rule would create a new category of broker-dealers called “Capital Acquisition Brokers” or “CABs”.  The proposed rule was published in the Federal Register on December 23, 2015 and will become effective after SEC approval, which normally occurs within 45 days after the date of publication. http://www.finra.org/sites/default/files/rule_filing_file/SR-FINRA-2015-054-federal-register-notice.pdf

Purpose of Proposal

The rule was developed based upon FINRA’s earlier release seeking comment on a proposal to create a new category of broker-dealers which limit their business activities to corporate financing.  See FINRA Regulatory Notice 14-09 (February 2014). As FINRA observed at that time, there are a number of broker-dealers which limit their business to advising companies on M&A transactions, raising funds through private placements and evaluating strategic alternatives.  While these firms must generally be registered as broker-dealers because they often receive transaction-based compensation, they do not handle customer funds or securities, do not manage customer accounts and do not engage in market-making or proprietary trading.¹ As a result, some of the requirements set forth in FINRA’s rules are not relevant to their business operations.

Limited Activities

In order to qualify as a Capital Acquisition Broker, a firm must limit its activities to the following:

  • Advising issuers, including private funds, concerning public or private securities offerings;
  • Assisting on the preparation of offering materials;
  • Acting as a placement agent in the sale of unregistered securities to institutional investors (as defined in the FINRA rules) and qualified purchasers (as defined in the Investment Company Act of 1940) through an exempt offering;
  • Advising a company regarding an M&A or restructuring transaction;
  • Providing fairness opinions;
  • Effecting the sale of securities in an M&A transaction involving the transfer of control of a privately held company;
  • Providing negotiation, structuring, valuation or other support for a capital raising or M&A transaction; and
  • Advising on the selection of investment bankers.

Importantly, broker-dealers that act as underwriters or selected dealers in registered public offerings could not qualify as CABs.  However, broker-dealers that limit their activities to advisory services in connection with public offerings could qualify as CABs.

Reduced Regulatory Requirements

Firms that limit their business activities as set forth above and which voluntarily elect to be treated as a Capital Acquisition Broker would be subject to a separate set of rules for CABs.  Important differences between the CAB rules and the FINRA rules applicable to other broker-dealers include:

  • CABs would be subject to a streamlined customer communications rule which dispenses with the process and filing requirements of Rule 2210, and essentially simply requires that communications be fair and balanced and not false or misleading.
  • CABs would not be subject to the rules governing mark-ups, commissions, etc. (Rules 2121, 2122 and 2124).
  • The rules governing supervision by CABs would be somewhat less demanding than the requirements of Rule 3110, and would dispense with the specific requirements in that rule regarding internal inspections, review of transactions, annual compliance meetings and certain documentation requirements.
  • CABs would not be required to have a business continuity plan.
  • CABs would be subject to streamlined requirements regarding the information they must obtain regarding their customers under Rule 4512.

Principal Benefits

Broker-dealers which qualify as CABs should be able to tailor their Written Supervisory Procedures and compliance function to focus on the matters which are of greatest concern to investment banking boutiques.  This should enable these firms to enjoy significant cost savings over time.  This could also help increase the number of firms that offer capital raising services to smaller companies.  Currently registered broker-dealers which wish to convert their status to that of a CAB may apply to do so by submitting an application to FINRA to amend their membership agreement.

¹ The SEC has exempted from broker-dealer registration firms which limit their activities to acting as advisors in connection with M&A transactions for privately held companies.  See https://www.sec.gov/divisions/marketreg/mr-noaction/2014/ma-brokers-013114.pdf

SEC Staff Publishes Guidance on Fund Distribution and Sub-Accounting Fees: Emphasis on Process and Fully Informed Directors

Posted in Fund Regulation

On January 6, 2016, the SEC’s Division of Investment Management published regulatory guidance and tackled the issue of how mutual funds, their investment advisers and independent fund directors should evaluate arrangements involving mutual fund distribution and fees paid for services related to sub-transfer agent, administrative, sub-accounting and other shareholder servicing fees (referred to as “sub-accounting fees” by the Division’s staff).

The Division’s staff urges fund boards to establish a robust process for evaluating and approving sub-accounting arrangements, and to ensure that funds establish compliance policies and procedures for reviewing and identifying any payments that are made for distribution-related services and that are not paid by a Rule 12b-1 distribution plan.

In the guidance, the staff hones in on the issue of whether payments of fees to intermediaries that are not characterized as distribution fees raise questions of whether some or all of those fees “are being used to pay for activities that are primarily intended to result in the sale of mutual fund shares.”  This is commonly referred to as “distribution in guise.”

For additional discussion and analysis, our Client Alert is available here.

FINRA’s 2016 Priorities Letter: Objective and Subjective Issues

Posted in FINRA Enforcement

2016 has arrived and, with the new year, FINRA has published its agenda of key examination priorities. This year’s 13-page Regulatory and Examination Priorities Letter sets forth both long-standing and new items for firms to evaluate in preparing for an examination. Not surprisingly, the letter is broad, and covers a wide range of areas; we indicate below our recommendations for firms that are preparing for an exam. Each member firm should, however, carefully assess the priorities identified in the letter in the context of its own busines

Read our client alert.

FINRA’s Securities Helpline for Seniors™ Provides Guidance to Broker-Dealers

Posted in FINRA Enforcement

In April 2015, the Financial Industry Regulatory Authority (“FINRA”) launched its Securities Helpline for Seniors™ (the “Helpline”). The Helpline seeks to enhance investor protection by serving as a resource to seniors making investment decisions. FINRA reports that, since its launch, the Helpline has fielded over 2,500 calls. The Helpline has received calls from persons ranging in age from 22 to 100; the average age of callers was 70 years old. Over the course of this initiative, FINRA has used the information gathered from these calls to assist seniors, detect fraud, and to identify ways that firms can guard against exploitation of seniors within their own organizations.

This article primarily focuses on this last point by highlighting the effective firm practices presented in FINRA’s year-end report of the Helpline. These practices are as follows:

  • Obtain the contact information, upon account opening, of a trusted person to reach out to for concerns about the senior’s account.
  • Avoid conflicts of interest by limiting a registered representative’s ability to occupy a position of trust, such as serving as a power of attorney or trustee, for their client.
  • Establish someone within the firm who focuses on, and serves as the contact person for, senior investor issues.
  • Train staff to identify potential client incapacity or elder abuse and to report these problems.
  • Publish client-focused educational materials to inform senior investors and help protect them from possible scams.
  • Keep your firm up to date on senior issues by joining industry groups focused on combating elder abuse and by hosting or attending symposiums discussing these issues.
  • Exercise caution in terminating relationships with aged clients.
  • Implement policies and procedures to handle instances of diminished mental capacity among employees of the firm.
  • Understand and carefully explain to clients the tax consequences of transferring assets from qualified accounts.
  • Ensure paperwork regarding distribution of account assets upon death accurately reflects the current wishes of the client.

The firm practices discussed in the report are not necessarily current rule requirements.  However, these practices represent helpful guidance from FINRA as to items that broker-dealers may wish to consider implementing as a “best practice.”  And of course, several of them may become the “law of the land,” as discussed in our summary of FINRA’s recently proposed Rules 4512 and 2165, which is available here.