Investment Management Law

Court Upholds Permanent Bar Even Though Rules Changed

2012-02-23T11:59:36Z

The U.S. Court of Appeals for the D.C. Circuit upheld a permanent bar against an investment adviser even though the alleged wrongdoing would not have been illegal following subsequent rule changes. The Court indicated that it will uphold SEC sanctions determinations unless â€œarbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.â€ The Court believed that the SEC properly applied a "multi-factor test" to determine that the public interest did not support lifting the bar because the adviser showed lack of remorse and failed to repay the amounts assessed against him. The case involved the mis-pricing of bonds using a methodology which the adviser claims would have been permitted under future FASB rules.

OUR TAKE: The SEC has broad discretion to impose (and maintain) sanctions against advisers, even where the underlying wrongdoing is not clear. Perhaps, the adviser would have had more chance had he paid off the assessments imposed in the initial order.

http://legaltimes.typepad.com/files/black_order.pdf

FINRA Considering Adding More Information to BrokerCheck

2012-02-22T12:02:41Z

FINRA has issued a Regulatory Notice seeking input about expanding the information available on the BrokerCheck program, which houses information about broker-dealers and registered representatives. The request is in response to SEC recommendations that BrokerCheck look more like the IARD system used for investment advisers. The SEC has asked FINRA to consider adding educational backgrounds, reasons for termination, and scores on qualification examinations. Additionally, FINRA asks whether it should release information to third parties for commercial purposes.

OUR TAKE: We think this initiative is related to FINRA’s ultimate goal of regulating both advisers and broker-dealers. A unified reporting system would smooth such a transition.

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p125621.pdf

SEC Raises Bar for Charging Performance Fees

2012-02-21T12:27:34Z

The SEC has issued a new rule that further restricts a registered adviser's ability to charge performance fees. Under the new rule, a registered adviser may only charge performance fees if the client has at least $1 Million under management with the adviser (up from $750,000) or a net worth of at least $2 Million (up from $1.5 Million). The net worth requirement excludes the value of a person's primary residence and mortgage indebtedness up to the home's fair market value but includes indebtedness that exceeds the home's FMV and indebtedness incurred within 60 days of the relevant calculation date. The rule applies to investors in private funds. Current investors (including follow-on investments) need not qualify so long as they qualified at the time of investment (including because a private fund manager was not required to register). However, a current investor into a new fund will be required to qualify if the investment occurs after the rule takes effect, which is expected to be May 2012. The Rule also requires indexing for inflation every 5 years. The rule codifies much of what the SEC ordered last July.

OUR TAKE: Private fund managers must implement procedures and change their subscription docs to ensure that current clients meet the new thresholds when a new fund is launched.

http://www.sec.gov/rules/final/2012/ia-3372.pdf

New CFTC Rule Will Require CPO Registration for Many Fund Managers

2012-02-14T12:42:48Z

The Commodity Futures Trading Commission has adopted a new rule that will require many fund managers to register as commodity pool operators. Rather than offering a complete exemption, advisers to funds that invest in futures, options, and swaps will only be exempt from CPO registration if they use such instruments solely for “bona fide hedging purposes” or they limit purchases such that aggregate margin and premiums do not exceed 5% of the fund’s liquidation value (or if the net notional value does not exceed 100 percent of the liquidation value of the fund’s portfolio). The CFTC did not exempt broad-based stock index futures or index products, as many in the industry requested. To stay within the exemption, funds will have to represent that they are not marketed as a commodity pool or as a vehicle for trading futures, options or swaps. The earliest compliance date is December 31, 2012. The CFTC is also working through harmonization of compliance requirements with SEC rules.

OUR TAKE: We suspect many fund advisers will simply choose to avoid investing in derivatives that will trigger CPO registration and CFTC regulation.

http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister020912b.pdf

Mid-Sized Advisers with Fewer than 5 Clients Must Register with the SEC

2012-02-13T12:34:07Z

The SEC’s Division of Investment Management has issued some new responses to frequently asked questions concerning Form ADV and IARD. Most significantly, the staff indicates that a firm with between $25 Million and $100 Million in assets under management (aka “mid-sized advisers”) that has fewer than 5 clients must register with the SEC if the adviser’s home state does not require registration for advisers with fewer than 5 clients. Upon obtaining its sixth client, the adviser would withdraw to state registration, but the adviser could wait until after filing its next annual amendment. The FAQs also address master-feeder arrangements including how to count beneficial owners of the master fund. The staff also indicates that private funds may use balance sheet gross asset figures to value derivatives for purposes of calculating regulatory assets under management.

OUR TAKE: The SEC has now added a new class of SEC registrants i.e. mid-sized advisers with fewer than 5 clients. This will affect limited purpose advisers such as family offices and wrap participants. It will also raise some confusion for private fund managers that have some limited separate account business.

http://sec.gov/divisions/investment/iard/iardfaq.shtml

Managers of 3(c)(1) Funds in Massachusetts Must Register by August 3

2012-02-10T11:59:58Z

The Massachusetts Securities Division has indicated that new regulations requiring 3(c)(1) fund managers to register went into effect on February 3 but will not be enforced until August 3. Although Massachusetts has not yet published the regulations, the MSD has indicated that they will be “almost identical” to those proposed in November. As we previously described (see link below), those proposed regulations require registration of advisers to 3(c)(1) funds unless all investors satisfy the "qualified client" definition under 205-3 of the Advisers Act. In addition to filing reports on Form ADV and paying certain fees, registering advisers would be required to make certain disclosures and deliver audited fund financial statements to investors. The proposed rule would require all investors to satisfy Rule 205-3 ($1.5 Million in net worth or $750,000 invested) after excluding the value of such investor's personal residence.

OUR TAKE: We believe that most of the other states will move in this direction i.e. require 3(c)(1) managers with less than $150 Million in AUM to register.

http://www.sec.state.ma.us/sct/sctnewregs_11_11/newregs_11_11_idx.htm http://blog.cipperman.com/2011/11/16/massachusetts-reproposes-registration-rule-for-3c1-fund-managers.aspx

SEC Files Notice of RIA Cancellation for Insufficient Assets

2012-02-09T11:20:44Z

SEC Files Notice of RIA Cancellation for Insufficient Assets (2/9/12; In re Gravity Capital Partners) In what may become a common occurrence, the SEC has filed a Notice of Intention to Cancel an adviser’s registration for failing to maintain sufficient assets under management. The Notice indicates that the SEC believes that the adviser does not have sufficient assets under management (now $90 Million) to maintain SEC registration. The adviser has 30 days to object.

OUR TAKE: It is much easier to withdraw to state registration rather than wait for the SEC to file a Notice of Cancellation. Also, the SEC could pursue enforcement proceedings for making false statements on an ADV.

http://www.sec.gov/rules/other/2012/ia-3369.pdf

BD to Pay $1 Million Fine for Requiring Employees to Waive Arbitration

2012-02-08T11:25:26Z

FINRA fined a large broker-dealer $1 Million for requiring employees to waive FINRA arbitration in promissory notes used as part of a bonus program. The firm used a non broker-dealer affiliate to pay retention bonuses structured as promissory notes. The notes required employees to waive arbitration so that any defenses to payment could only be brought in a New York State court, which, according to FINRA, “greatly limits the ability of defendants to assert counterclaims in such actions.” FINRA alleges that the practice violated FINRA rules requiring firms to arbitrate disputes with employees. Over 5,000 reps signed the notes, representing $2.8 Billion in retention bonuses.

OUR TAKE: The firm was too clever by half in trying to obviously circumvent FINRA arbitration. With this many annoyed brokers, somebody was bound to squawk to FINRA.

http://www.finra.org/Newsroom/NewsReleases/2012/P125455

Fund Service Provider Employees Do Not Get SOX Whistleblower Protection

2012-02-07T11:38:04Z

The United States Court of Appeals for the First Circuit has ruled that employees of a public mutual fund's service providers are not entitled to Sarbanes-Oxley whistleblower protection. The plaintiffs had claimed retaliation for raising issues concerning a mutual fund for whom their employers provided advisory and other services. The court concluded that Sarbanes-Oxley only protected employees of the public company (i.e. the fund) and not employees of private companies that provide services to the public company. The Court relied on statutory language and legislative history and disregarded SEC and OSHA interpretations.

OUR TAKE: As a matter of principle, we agree with the Court that Sarbanes-Oxley was not intended to cover employees of service providers. However, the question becomes more difficult in the fund context where the public company only operates through service providers. We expect to hear more about this issue from other courts and possibly the Supreme Court.

http://www.ca1.uscourts.gov/cgi-bin/getopn.pl?OPINION=10-2240P.01A

SEC's di Florio Calls Out Senior Management and Boards

2012-02-06T12:16:43Z

In a recent speech, Carlo di Florio, the SEC's Director of the SEC's Office of Compliance Inspections and Examinations, said that the SEC wants to put more compliance responsibility on senior management and boards. According to Mr. di Florio, the SEC "will focus most intently on firms where we sense that senior management and the board are not setting the appropriate tone and are failing to support key risk and control functions with adequate resources, independence, standing and authority." He indicated that "an effective risk governance framework" begins with the business units as the "first line of defense" to manage and supervise risk in accordance with laws. Compliance serves as a support function. Then, internal audit should provide independent verification. He indicated that OCIE will seek "to engage senior management and the board on critical business, risk and regulatory issues."

OUR TAKE: We believe this means that firms will not be able to shield senior management from SEC examiners. It may also mean personal liability for senior managers found not to have supported the compliance function through resource allocation and decision-making.

http://www.sec.gov/news/speech/2012/spch013112cvd.htm

Top 5 Regulatory Alerts for January 2012

2012-02-03T11:39:24Z

Our top 5 Regulatory Alerts for January 2012:

1. SEC Sues Fund Portfolio Manager for Holding Back Valuation Information (1/19/2012)

2. SEC Staff Allows Related Private Fund Advisers to Rely on Single Registration (1/23/2012)

3. SEC Staff Provides Guidance on Family Office Registration Rule (1/25/2012)

4. SECâ€™s OCIE Issues Risk Alert on Adviser Use of Social Media (1/5/2012)

5. Fund Sponsor to Pay $300,000 for Not Following Valuation Procedures (1/18/2012)

FINRA Sues BD for Including Class Action Waiver in Client Agreement

2012-02-02T12:20:21Z

FINRA has filed an enforcement action against a large broker-dealer/custodian for requiring customers to waive their right to bring or participate in class actions. According to FINRA, the class action waiver contained in the client agreement violates FINRA rules because FINRAâ€™s Code of Arbitration Procedure permits class actions. Therefore, the class action waiver contradicts the rules of an SRO.

OUR TAKE: FINRAâ€™s reasoning is weak. Just because FINRA arbitration allows class actions does not mean that firms are prohibited from including class action waivers. FINRA appears to be adopting a new rule through enforcement litigation. Is this yet another reason why advisers fear FINRA as a regulator?

http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p125516.pdf

FINRA Releases Exam Priorities List; Announces Risk Survey

2012-02-01T11:55:27Z

FINRA has released its annual Regulatory and Examination Priorities letter, highlighting â€œareas of significanceâ€ for the examination and enforcement staffs. The comprehensive 16-page letter highlights 28 areas of focus where firms should assess whether they have sufficient internal controls, supervisory systems, and risk management practices. Among the highlights include suitability for retail customers (especially complex products), supervision of private securities transactions and outside business activities, information technology and security, outsourcing, social media and electronic communications, and pricing of hard-to-value securities. FINRA also indicates that firms will be receiving a Risk Control Assessment Survey to help FINRA â€œbetter understand firmsâ€™ business activities, product mix, customer base, and underlying controls.â€

OUR TAKE: The usefulness of a â€œpriorities listâ€ declines as the list grows to encompass most of the areas that FINRA regulates. However, the letter does help compliance officers build checklists for internal reviews and resource allocation.

http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p125492.pdf

Firm and Principal Sanctioned for Failing to Supervise Independent Contractor

2012-01-31T11:32:30Z

The SEC sanctioned a broker-dealer and its principal for failing to supervise an independent contractor that was perpetrating a Ponzi scheme. The SEC charges that a properly implemented supervisory system would have uncovered the fraud. According to the SEC, the firm did not provide previous compliance audit reports to subsequent auditors and did not perform unannounced audits. As a result, the firm failed to identify the repâ€™s continuing pattern to mislead clients about his operations and affiliation with the firm. The SEC also charges that the firm should have investigated rapidly declining commissions. Citing the Royal Alliance case (1997), the SEC said that the firm had a heightened supervisory obligation because it operated through independent contractors that utilized â€œDBAâ€ names and offices.

OUR TAKE: Through the recent recession, we have seen the resurrection of the independent contractor model because firms are less willing to commit resources. Firms should note the heightened supervisory obligations.

http://www.sec.gov/litigation/admin/2012/34-66212a.pdf

Firms Must Verify Funds Transfer Instructions

2012-01-30T15:04:26Z

FINRA has issued a Regulatory Notice advising firms to reassess their policies and procedures for accepting instructions via e-mail in light of recent hacking cases. Various law enforcement authorities have warned the industry that third party hackers have gained unauthorized access to e-mail accounts and then sent funds transfer instructions to broker-dealers, many of whom followed the instructions without verification. FINRA warns firms that policies and procedures should (a) include some sort of verification to ensure that transfer instructions actually came from the customer and (b) identify red flags such as requests that are out of the ordinary, instruct transfers to an unfamiliar third party, or indicate urgency. FINRA notes that both introducing and clearing firms should have the necessary policies and procedures.

OUR TAKE: Both advisers and broker-dealers should consider verification. The key will be to educate clients that live contact will be required before moving funds.

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p125462..pdf

BDs Must Make SAR Information Available to FINRA

2012-01-27T11:17:30Z

The SECâ€™s Office of Compliance Inspections and Examinations has issued an open letter to all FINRA member broker-dealers instructing them to make all Suspicious Activity Reports and related documentation available to FINRA during examinations. The letter implements changes to the Bank Secrecy Act. FINRA, in turn, must keep such information confidential. Required information includes Suspicious Activity Reports, supporting documentation, and â€œany information that would reveal the existence of a SAR or any decision to not file a SAR.â€

OUR TAKE: The change delegates to FINRA supervision of broker-dealer compliance with the Bank Secrecy Act.

http://sec.gov/about/offices/ocie/brokerdealerletter.htm

http://sec.gov/about/offices/ocie/finraletter.htm

SEC Staff Provides Guidance on Family Office Registration Rule

2012-01-25T12:51:57Z

The staff of the Division of Investment Management has issued answers to certain questions arising under the new family office rule, which exempts single family offices from adviser registration. Significantly, the responses make clear that merely serving as a family office does not trigger adviser registration so long as the office only provides non-advisory services such as tax filings, accounting, and housekeeping. The responses also state that same-sex domestic partners and opposite sex partners that live together would be considered â€œspousal equivalentsâ€ for purposes of the rule. The responses also address control issues and investments by key employees.

OUR TAKE: Given the wide range of family structures and relationships, we expect the staff to receive many inquiries over time about the contours and limits of various rule provisions.

http://sec.gov/divisions/investment/guidance/familyofficefaq.htm

FINRA Warns Firms about Recommending Complex Products

2012-01-25T12:51:12Z

FINRA has issued a Regulatory Notice advising firms to implement a heightened supervisory system when recommending complex products. FINRA defines a â€œcomplex productâ€ as any product â€œwith multiple features that affect its investment returns differently under various scenarios.â€ FINRA provides a non-exclusive list of complex products: asset-backed securities, unlisted REITs, any product with an embedded derivative component (i.e. reference to another asset), structured notes, investments tied to the performance of other markets, principal-protected notes, and leveraged or inverse ETFs. Recommended supervisory procedures include a more robust product approval process, an ongoing review to determine if the products performed as anticipated, extensive training of registered representatives, and limiting sales to customers that would qualify for options trading.

OUR TAKE: If the product is not an equity, treasury, or mutual fund, treat it as a complex product.

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p125397.pdf

SEC Staff Allows Related Private Fund Advisers to Rely on Single Registration

2012-01-23T11:19:18Z

The staff of the Division of Investment Management has issued a no-action letter allowing private fund managers that operate through multiple entities to rely on a single adviser registration provided certain conditions are observed. The staff acknowledged that private fund advisers often utilize a group of related advisers for a variety of tax, legal and regulatory reasons. The staff indicated that only one adviser of the group needs to register if the group meets several conditions: (i) all of the advisers are under common control; (ii) each adviser has sufficient assets ($150 Million) to register with the SEC (unless operating from the same location); (iii) the advisers manage only private funds and substantially similar separate accounts for qualified clients; (iv) all persons in the group are deemed "associated persons" and therefore subject to a single Code of Ethics; (v) each adviser is subject to the Advisers Act including a compliance program and SEC examination; and (vi) appropriate disclosure is made on Schedule D of Form ADV for the registering adviser. The staff also indicated that it will still follow prior guidance that a special purpose vehicle formed to serve as a general partner of a private fund need not register if the affiliated investment adviser is registered so long as the GP and its personnel are subject to the Advisers Act.

OUR TAKE: While we don't think the staff's position is a surprise given the staff's prior positions, the conditions imposed may be difficult to satisfy. For example, if one of the relying advisers has less than $150 Million in assets, it may have to register separately with its home state if it has a separate office location. Also, the conditions may force many firms to change their current structure if they hope to rely on the no-action relief.

http://sec.gov/divisions/investment/noaction/2012/aba011812.htm

SEC Sues Fund Portfolio Manager for Holding Back Valuation Information

2012-01-19T12:28:15Z

The SEC has commenced an enforcement proceeding against the portfolio manager of a mutual fund for failing to inform the Valuation Committee of certain events that affected the valuation of an underlying security. As a result, the SEC charges that the fund overstated its NAV, which allowed the fundâ€™s adviser to receive inflated advisory fees. The SEC alleges that the portfolio manager was informed by the trustee for the underlying security (a CDO in subprime mortgages) that an event of default occurred and that, as a result of acceleration declared by senior security-holders, the fund would not receive future coupon payments. The respondent failed to inform her firmâ€™s Valuation Committee even though the firmâ€™s policies and procedures required portfolio managers to review all prices on a daily basis and notify the Valuation Committee of prices not representing fair value. Once the Valuation Committee became aware of the valuation impairment, it wrote down the security, which led to a run on the fund and its ultimate liquidation. The SEC alleges direct violations of the Adviser Actâ€™s anti-fraud rules as well as aiding and abetting.

OUR TAKE: Most fair valuation procedures require the portfolio managers to monitor security valuations daily and immediately inform the valuation committee of any impairment issues. Many portfolio managers are reluctant to write down securities. This case shows that the SEC will pursue portfolio managers individually for failing to undertake their stated responsibilities.

http://sec.gov/litigation/admin/2012/ia-3355.pdf