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The BD/IA Regulator

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

Broker-Dealer Settles Record Keeping Charges for $1.25 Million

Posted in Broker-Dealer Regulation, SEC Enforcement

On July 17, 2018, the SEC announced that it had entered into a settlement with a broker-dealer charged with failure to preserve certain records and inaccurately recording travel, entertainment, and other expenses. The broker-dealer agreed to pay a $1.25 million penalty to settle the charges.

The SEC found that after receiving document requests from the SEC’s Division of Enforcement, the broker-dealer deleted audio files for certain recorded telephone lines that were responsive to the document requests. According to the SEC, the files were deleted in accordance with the firm’s records policy after an unrelated litigation hold was lifted. Although the broker-dealer had issued a separate litigation hold notice after receiving the SEC staff’s document request, it did not ensure that this litigation hold notice was distributed to the technicians in the department responsible for maintaining voice recordings.

The SEC also found that the broker-dealer failed to maintain books and records that accurately recorded compensation, travel, entertainment, and gifts. For example, the SEC found that the broker-dealer provided a high-performing broker with season tickets worth more than $600,000 per year and did not record the cost of the tickets as compensation in its general ledger. The SEC also found that the broker-dealer reimbursed certain brokers for expenses associated with travel and other personal expenses without a sufficiently documented business purpose, and that the broker-dealer recorded certain gifts to customers as entertainment rather than gifts.

According to the SEC staff, the “failure to preserve and produce responsive documents undermines the Commission’s ability to provide effective oversight of registrants and to carry out its mission to protect investors.” The broker-dealer settled the charges without admitting or denying the SEC’s findings.

Our Take

Broker-dealers and other registrants need to ensure that their policies and procedures include policies designed to ensure compliance with applicable record keeping obligations. Although record keeping violations will often appear as secondary deficiencies or violations, they are grounds for separate SEC enforcement action, as this broker-dealer found out the hard way.

FINRA Asks Members: What Are You Doing with Digital Assets?

Posted in FINRA Enforcement

In a July 2018 regulatory notice (Regulatory Notice 18-20, available here: http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-20.pdf), FINRA has requested that members notify it if they engage, or intend to engage, in any activities related to digital assets, such as cryptocurrencies. In addition, until July 31, 2019, FINRA requests that firms notify their point of contact with FINRA, their regulatory coordinators, if they begin to engage in new activities of this type. Relevant activities include, among other things:

  • transactions in or advice regarding digital assets;
  • transactions in or advice regarding pooled assets investing in digital assets;
  • transactions in derivatives, such as futures and options, and perhaps structured products that are linked to digital assets;
  • offerings of digital assets, such as initial coin offerings;
  • accepting payment from customers in the form of cryptocurrencies; and
  • mining cryptocurrencies.

The above non-exclusive list does not include activities relating to companies that are engaged in the digital asset sector, such as participating in equity offerings of companies that are engaged in digital asset technology. Although absent from this list, broker-dealers have to be mindful of their investor suitability, due diligence, and other obligations in participating in offerings relating to new and potentially volatile industries.

It is premature to determine whether any new rules or regulations or guidance will emerge. First, FINRA needs to understand the asset class better, learn about broker-dealer activities in the area, and whether there are potential risks for investors as a result of these activities.

Massachusetts Takes on Risky Broker-Dealers That Offer Private Placements

Posted in Broker-Dealer Regulation

On July 2, 2018, the State of Massachusetts announced that it was investigating 10 broker-dealers that have 15% or more of their agents with current disciplinary incidents and that offer private placements to individual investors.

According to the announcement, the investigation arises in large measure due to a recent Wall Street Journal investigation into these types of firms, which targeted senior investors in particular. The Wall Street Journal’s article on the subject can be found at the following link: https://www.wsj.com/articles/firms-with-troubled-brokers-are-often-behind-sales-of-private-stakes-1529838000. In addition, it should be noted that the State of Massachusetts has a reputation for aggressively pursuing brokers that it believes may have engaged in improper sales practices.

Private placements encompass a broad range of financing transactions, including venture capital investments made by “angels,” bespoke complex securities offered to hedge funds and equity offerings made by private companies and small public companies targeting higher net worth individual investors. The Massachusetts initiative appears to be focused on the last category of private placements, where brokers may be incentivized to offer these securities with commissions as high as 10% of the offering price. Due to the higher potential fees and the lack of liquidity generally associated with securities offered through private placements, and because they tend to be less transparent than public offerings, it is not a surprise that such transactions are a focus for regulators.

The fact that a broker-dealer employs agents with a disciplinary history does not necessarily mean that private placements are being sold through improper sales practices or to accounts for which such investments may not be suitable. However, these types of employees, combined with the higher commissions and greater risks often associated with these securities, together could perhaps be viewed by some as “circumstantial evidence” of improper practices. The Wall Street Journal review provides empirical support for this proposition.

New Exemptive Rule Could Lower Barriers to Entry for New ETFs

Posted in Uncategorized

At an open meeting held June 28, 2018, the SEC voted unanimously to propose a new rule codifying exemptions to certain rules under the Investment Company Act.  These exemptions have enabled the exchange-traded fund (ETF) industry to grow to more than $3.4 trillion in 24 years.  In order to even the playing field for existing ETFs and new entrants to the market, the proposed rule would rescind the existing exemptive orders upon which most ETFs currently operate.

Like mutual funds, ETFs continuously offer their shares for sale.  Unlike mutual funds, however, investors in ETFs cannot purchase or redeem individual shares directly with the fund.  Instead, “authorized participants” enter into contractual arrangements with an ETF’s distributor to purchase and redeem ETF shares in “creation units.”  That is, the authorized participant deposits with the ETF a “basket” of securities and other assets, and the ETF issues a creation unit of ETF shares in return for those assets.  The basket is representative of the ETF’s portfolio and is identified by the ETF daily.  After purchasing a creation unit, the authorized participant may hold individual ETF shares or sell individual shares to individual investors in secondary market transactions.  ETF shares may trade at a premium or at a discount to net asset value, which provides authorized participants with arbitrage opportunities that can help keep the market price of ETF shares close to the fund’s net asset value.

In order to operate in this fashion, ETFs need exemptions from certain rules and sections under the Investment Company Act.  Proposed Rule 6c-11 would eliminate the need for most ETFs to obtain individual exemptive relief.

As proposed, Rule 6c-11 would only be available to ETFs organized as open-end funds.  ETFs that are organized as unit investment trusts or structured as a share class of a multi-class fund would not be able to rely on the proposed rule.  Leveraged or inverse ETFs would also be precluded from relying on the proposed rule.  The excluded ETFs would continue to rely on existing exemptive relief.

Under proposed Rule 6c-11, an ETF would be required to provide daily portfolio transparency on its website. ETFs would also be required to disclose information regarding historical premiums and discounts to net asset value and bid-ask spread information.  The SEC said that these disclosures are intended to inform investors about the efficiency of an ETF’s arbitrage process.

Under the proposed rule, ETFs would also need to post on their websites information regarding a published basket at the beginning of each business day.  ETFs would be permitted to use baskets that do not reflect a pro-rata representation of a fund’s portfolio or that differ from other baskets used in transactions on the same business day (“custom baskets”), provided that such ETFs would be required to adopt written policies and procedures setting forth detailed parameters for the construction and acceptance of custom baskets.  The board of an ETF using custom baskets would be required to find such use to be in the best interests of the ETF and its shareholders.

This is not the first time that the SEC has proposed a rule aimed at codifying the existing exemptive regime for so-called “plain vanilla” ETFs.  Rule 6c-11 was first proposed in 2008, but the intervening global financial crisis required the SEC and its staff to refocus attention on rule-making under the Dodd-Frank Act.  In the interim, new entrants to the ETF market have had to obtain individual exemptive orders, a process that is both lengthy and costly.  Adopting proposed Rule 6c-11 should meaningfully lower the barriers to entry for new entrants to the ETF space.

Comments on proposed Rule 6c-11 will be due 60 days from publication of the proposed rule in the Federal Register.

AICPA Draft Guide Available for Comment: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds

Posted in Uncategorized

The AICPA recently released for public comment a working draft of its Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”).

The Guide is designed to provide investment companies that invest in securities issued by privately held enterprises with an overview of the valuation process and the roles and responsibilities of the various parties involved in the valuation process.  It also includes best practice recommendations for complying with FASB ASC 946:  Financial Services—Investment Companies and FASB ASC 820: Fair Value Measurement.  Investment companies within the scope of FASB ASC 946 include private equity funds, venture capital funds, hedge funds, and business development companies.

Importantly, the Guide does not change existing accounting guidance.  The Guide was prepared by the AICPA Private Equity and Venture Capital Task Force and was approved for issuance by the AICPA Financial Reporting Executive Committee.  As such, it is non‑authoritative.  Rather, the Guide seeks to provide funds with interpretive guidance regarding valuation of investments in equity and debt securities issued by privately held enterprises.

In drafting the Guide, the Task Force considered various accounting and valuation issues that have come up over time.  The Guide first provides an overview of the private equity and venture capital industries and related investment strategies.  It then summarizes FASB ASC 820 fair value measurement concepts (which updated fair value and measurement disclosures codified in FASB Statement 157:  Fair Value Measurements) and provides guidance on market participant assumptions, unit of account, and an overview of valuation approaches (i.e., the market approach, income approach, and asset approach).  The Guide also has chapters addressing restrictions on transfer, calibration, back-testing, and factors to consider at or near a transaction date, and includes frequently asked questions and appendices addressing documentation considerations and case studies.

Comments on the working draft are due to the AICPA by August 15, 2018.  A final version of the Guide is expected to be released in May 2019.

SEC Brings 13 Settled Enforcement Proceedings for Failure to File Form PF

Posted in Investment Adviser Regulation, SEC Enforcement

On June 1, 2018 the SEC announced that it entered into settled enforcement proceedings with 13 registered investment advisers. According to the settled orders, the advisers failed to file and update Form PF over multi-year periods, in violation of Rule 204(b)-1 under the Investment Advisers Act of 1940.  Each of the advisers agreed to a $75,000 civil money penalty.

Rule 204(b)-1 requires registered investment advisers with at least $150 million in private fund assets under management to file and update Form PF at least annually. The Form provides the SEC with information about private funds that is uses to monitor industry trends, inform rulemaking, identify compliance risks, and target examinations and enforcement investigations.  The Financial Stability Oversight Council also uses Form PF information to monitor systemic risk posed by the private fund industry.

According to the SEC, the failure to file Form PF deprived the agency of key information necessary to its regulatory initiatives, including the amount of assets under management, fund strategy, performance, and use of borrowed money and derivatives. The SEC encouraged investment advisers to “take a fresh look at whether they are meeting their reporting obligations and adjust their compliance programs accordingly.”

The SEC noted that, during the investigation, each adviser remediated its failures by making the necessary filings.

Our Take

Although the size of these penalties was modest, the SEC’s decision to bring these actions in a coordinated manner is a means of reminding registered advisers of their filing obligations. If the SEC continues to identify violations of these filing obligations, we expect that any future settlements would include larger penalties.  In addition, regardless of the size of these penalties, the public nature of the sanctions could adversely affect the investment advisers since institutional investors typically ask about enforcement matters during the diligence process.

Investment advisers with over $150 million in assets under management should ensure that they have made the necessary Form PF filings and, if not, should take prompt action to remedy that omission. Advisers that currently file with the SEC as exempt reporting advisers but are likely to cross the $150 million threshold before the end of their next fiscal year should be aware that, in addition to updating their Form ADV to include information about assets under management and a narrative brochure, they will be subject to Form PF filing requirements and ensure that their compliance policies are appropriately updated.

CFTC Staff Issues Interpretation Regarding Position Limits Aggregation by Passive Investors in Commodity Pools

Posted in Fund Regulation

On May 2, 2018, staff of the Division of Market Oversight of the Commodity Futures Trading Commission (“CFTC”) issued an interpretation regarding CFTC Reg. 150.4(b)(1), 17 CFR 150.4(b)(1), which provides an exemption from the CFTC’s position limits aggregation rules for certain passive investors in commodity pools (CFTC Staff Letter No. 18-12).

In general, market participants are required to aggregate all positions in accounts for which the person, by power of attorney or otherwise, directly or indirectly controls trading or holds a 10 percent or greater ownership or equity interest, absent an exemption. CFTC Reg. 150.4(b)(1) provides an exemption from aggregation to a person who is a passive investor (i.e., a person that is a limited partner, limited member, shareholder, or other similar pool participant) that holds a 10 percent or greater ownership or equity interest in a commodity pool, unless the person is excluded by one of the three exceptions contained in the regulation.

The requestor of the interpretation asked the CFTC staff to consider a situation in which a large institutional investor, through its passive ownership interest in private equity or venture capital funds that retain the right to invest in commodity interests and thus are considered commodity pools, might indirectly own more than 10 percent of an underlying “portfolio company” in which the pool was invested. Such portfolio companies were operating companies that might be engaged in commercial operations in the agricultural and energy sectors. The requestor sought clarification that it would not be required to aggregate any commodity interest positions that might be held by these portfolio companies by virtue of its indirect ownership interest through its passive pool investment.

The CFTC staff’s interpretation clarifies that, so long as the institutional investor is otherwise eligible for the aggregation exemption in CFTC Reg. 150.4(b)(1) (i.e., a passive investor in a commodity pool eligible to rely upon the exemption and not excluded through one of Reg. 150.4(b)(1)’s three exemptions) and did not either control trading for, or have another relationship with, the portfolio company that would require aggregation (such as an express or implied agreement to trade in concert), the investor would not be required to “look through” the commodity pool to aggregate the positions of the underlying portfolio companies invested in by the pool with its own positions. In other words, the interpretation clarifies that the institutional investor’s CFTC Reg.150.4(b)(1) aggregation exemption with respect to its investment in a commodity pool extends to its 10 percent or greater indirect interest (via the pool) in portfolio companies for which it does not control trading or have another relationship requiring aggregation. The interpretation notes, however, that it does not apply in a situation in which a passive investor invests in alternative or parallel funds with the intention to circumvent position limits.

The interpretation is available here.