The SEC has just published additional guidance for those venture capital funds advisers relying on an exemption to not register as investment advisers under the Investment Advisers Act of 1940, and who may worry that the way they structured a fund (or whether certain actions discussed below) might jeopardize the ability to rely on the exemption. In response to such inquiries, the SEC’s Division of Investment Management has provided additional guidance in the form of five examples or “scenarios” for advisers relying on the “venture capital fund” exemption or “VC Exemption” where they advise one or more venture capital funds. First, some background:
In Regulatory Notice 13-76, FINRA reminds broker-dealers and investment advisers that the 2014 Renewal Program began on November 11, 2013, when FINRA made the online Preliminary Renewal Statements available to all firms on Web CRD/IARD.
Beginning November 1, 2013, firms could begin submitting post-dated Form U5, BR Closing/Withdrawal, BDW and ADV-W filings via Web CRD/IARD. FINRA’s 2014 Renewal Program Calendar reminds of critical renewal dates. First, Preliminary Renewal States were available beginning November 11, 2013 on Web CRD/IARD. Second, by December 13, 2013, full payment of Preliminary Renewal Statements is due. Third, on January 2, 2014, Final Renewal Statements are available on Web CRD/IARD. Fourth, full payment of Final Renewal Statements is due by January 10, 2014.
FINRA also warns firms that failure to remit full payment of their Preliminary Renewal Statements to FINRA by December 13, 2013, may cause the firm to become ineligible to do business in the jurisdictions where it is registered, effective January 1, 2014 and be subject to late fees.
As they were required to do under the Dodd-Frank Act, the SEC announced that it has now voted to adopt permanent rules requiring municipal advisors to register. Previously, and immediately after Dodd-Frank, municipal advisors were placed under a temporary registration requirement, and following it, more than 1,100 municipal advisors registered with the SEC.
The permanent rule, the SEC says, will address the long concern about the fallout from losses suffered, in part, by municipalities purchasing complex derivatives products and relying on the advice from unregulated advisors — advisors, who municipalities may not have been aware, may have had conflicts of interest. In addition to defining the term “municipal advisor,” and who is exempted from that definition, the rule identifies when a person is considered to be providing “advice.” For example, the SEC says, other than general giving information, a person recommending to a municipal entity advice based on a particular need related to municipal financial products or related to the muncipalities’ issuance of municipal securities would be considered providing muncipal advice.
The SEC’s Press Release states that the new rules will be effective 60 days after publication in the Federal Register.
In a speech before the PLI Hedge Fund Management Conference in New York, Norm Champ, the SEC’s Director of the Division of Investment Management, addressed the increased oversight advisers to hedge funds relying on private offering exemptions can expect. Of concern is the adopted amendments to rules under the Securities Act of 1933 permitting general solicitation and general advertising in private securities offerings relying on Rule 144A or Rule 506 under the Securities Act and the rule’s disqualifying of so-called “bad actors” who rely on its safe harbor.
In short, as to advertising, Rule 506 eliminates the prohibition on general solicitation and general advertising for some private fund offerings, with exceptions noted in the rule. Generally, to find potential accredited investors, once the removal of the ban goes effective in the next few weeks, hedge fund will be able to use certain other methods of solicitating and advertising. With this comes the requirement that issuers take reasonable steps, defined by an objective assessment standard, to verify “accredited investor” status, to ensure that all purchasers of the securities are accredited investors. Champ also stressed the importance of advisers maintaining, reviewing and updating their policies and procedures to ensure, among other things, they are reasonably designed to prevent the use of fraudulent or misleading advertisements.
Other issues hedge funds will need to concern themselves with, related to general solicitation, and included in SEC proposals and related request for industry comment, include the following:
- requiring issuers to file the Form D before a general solicitation begins and when an offering is completed to evaluate how general solicitation impacts investors in the private placement market, and expanding the information that issuers must include on Form D.
- requiring private fund issuers to include a legend in any written general solicitation materials disclosing that the securities being offered are not subject to the protections of the Investment Company Act of 1940.
- requiring general solicitation materials containing performance data, to have additional disclosure explaining the context and limitations on the usefulness of such data.
- extending to private funds Rule 156 of the Securities Act of 1933 guidance on when information in sales literature could be fraudulent or misleading under federal securities laws currently applicable to registerd funds.
- manner and content restrictions on private fund solicitation materials that include performance advertising specific to certain types of performance advertising, such as model or hypothetical performance.
- using an inter-Divisional group within the SEC to assess practices and developments in the Rule 506(c) market place, by looking at accredited investor verification practices used by issuers and other participants in these offerings, and studying risk characteristics that might identify potentially fraudulent behavior.
- reviewing the definition of accredited investor as it relates to natural persons.
The “Bad Actor” Disqualification
As for the “bad actor” rule, the second amendment to Rule 506 implementing
Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Champ warned of serious regulatory consequences should the SEC make a bad actor finding. To avoid the finding, hedge fund advisers should conduct appropriate due diligence when they hire employees, third-party solicitors, and when they screen investors. Champ also reminded hedge funds that while disqualification applies only for triggering events that occur after the effective date of the rule, matters that existed before the effective date of the rule that would otherwise be disqualifying must be disclosed to investors.
Generally, an issuer cannot rely on the Rule 506 exemption from registration if the issuer or any other person covered by the rule is disqualified by a “triggering event,” including certain criminal convictions, certain SEC cease-and-desist orders and court injunctions and restraining orders. Hedge funds are not the only potential “bad actors. ” Others, Champ reminded, could include “the hedge fund’s general partner or managing member, its investment adviser and principals, significant shareholders holding voting interests, affiliated issuers and any placement agent or other compensated solicitor.”
Finally, from a risk perspective, how will the SEC determine which hedge funds engaged in general solicitation to examine and/or investigate?
One way, he notes, is that registration and reporting reforms related to Dodd-Frank, over the past few years, including, the adoption of amendments to Form ADV and the creation of Form PF allows the SEC to cull more information about individual hedge fund’s practices. Another way, is the Division of Investment Management establishment of a Risk and Examinations Office (“REO”) staffed with analysts with strong quantitative backgrounds, along with examiners, lawyers and accountants who will conduct quantitative and qualitative financial analysis of the investment management industry, including private funds, advisers, types of funds, strategies and make up of a fund.
The SEC has issued a new Risk Alert stemming from its observations of the business continuity and disaster recovery planning practices of a number of investment advisers. The alert follows an National Examination Program (“NEP”) review of the plans of approximately 40 investment advisers following Hurricane Sandy. The SEC says the goal is to encourage investment advisers to review their business continuity and disaster recorvery plans (“BCPs”) to improve responses and recovery times for threats that might disrupt market operations.
Certain weakenesses observed, and that advisers would do well to heed, include the following areas:
- Preparation for widespread disruption. Some advisers whose BCPs did not adequately address and anticipate widespread events experienced more interruptions in their key business operations and inconsistent communications with clients and employees.
- Planning for alternative locations. Some advisers who switched to back-up sites or systems reported that the buildings where they usually conduct their business were closed for days. At least, one adviser reported its building was closed for several weeks. Other problems included extended outages of power, phone systems, and internet service and lack of geographically diverse office operations.
- Preparedness of key vendors. Some advisers failed to even evaluate the BCPs of their service providers or keep a list of vendor’s contact information. Some advisers did not acquire or critically review service providers’ Statement on Standards for Attestation Engagements No. 16 reports.
- Telecommunications services and technology. Some advisers failed to hire service providers to make sure back-up servers functioned properly, relying solely on self-maintenance, which led to more interruptions in their operations.
- Communication plans. Poor planning, inconsistencies and weak deployment in how to contact employees during a crisis. Some plans did not identify which employees would execute and implement various parts of the BCP.
- Reviewing and testing. Inadequate testing of operations and systems relative to size and nature of advisory businesses. Some problems here were based on adviser failures to conduct certain critical tests based on costs and other disincentives.
The risk alert also encourages advisers to consider those best practices and lessons learned that were described in the Joint Review of Business Continuity and Disaster Recovery of Firms by the Commission’s National Examination Program, the Commodity Futures Trading Commission’s Division of Swap Dealers and Intermediary Oversight and the Financial Industry Regulatory Authority on August 16, 2013. They are available at http://www.sec.gov/about/offices/ocie/jointobservations-bcps08072013.pdf.
While the alert serves as a friendly reminder, to avoid a potential enforcement action, the advice covered should be reviewed, and where appropriate, implemented. The days of preparing a boilerplate disaster recovery handbook to be left to collect dust on an adviser’s bookshelf have long passed.
The SEC’s Office of Compliance Inspections and Examinations (OCIE) has now issued a new Risk Alert raised by its examination staff’s observation that some options trading strategies are being used to evade the short-sale rule, Rule 10b-21. The alert addresses the need for customers, broker-dealers and clearing firms to be aware of options trading activity that could be used to avoid complying with the close-out requirements of Reg SHO.
Under the rule, it is fraudulent to sell an equity security if it deceives a person participating in the transaction about the seller’s intention or ability to deliver the security by settlement date. Rule 10b-21 covers such situations where a seller deceives a broker-dealer, participant of a registered clearing agency, or a purchaser about its intention to deliver securities by settlement date, and the seller then fails to deliver securities by settlement date. The violative activity would include broker-dealers (including market makers) acting for their own accounts. Broker-dealers could also be held liable for aiding and abetting a customer’s fraud under Rule 10b-21.
In addition to addressing, with examples, trading strategies that could be used to circumvent Reg SHO requirements, and other helpful ways that OCIE has observed that some firms have used to effectively detect and prevent violation of the rule, the alert provides summary guidance covering (a) Reg SHO Close-out Requirement; (b) Reg SHO Locate Requirement; (c) Rule 10b-21; (d) Key Trading Terms and Concepts; and (d) Option Activity Related to Hard to Borrow and/or Threshold Securities.
Two SEC enforcement cases last week demonstrate (i) how using affiliated brokerage on an agency or principal basis raises potential conflicts of interest when dealing with ” best execution” concerns , and (ii) the importance of having robust best execution policies and procedures and then following them. In both cases, the SEC sanctioned investment advisers for not heeding these concerns in failing to seek best execution on client trades placed through in-house brokerage divisions.
While the duty of an adviser or fund to seek best execution may not expressly be stated in the federal securities laws, to the extent they are typical, these cases tend to follow a pattern: An SEC best execution enforcement action might involve the SEC’s examination staff first finding that a firm failed to disclose compensation on client brokerage, failed to adequately its brokerage practices or failed to properly disclose to clients the adviser’s best execution policies and procedures. The two recent cases are no exception.
In the first case against A.R. Schmeidler & Co. (ARS), a dually registered investment adviser and a broker-dealer, the SEC found that ARS failed to reevaluate whether it was providing best execution for its advisory clients when it negotiated more favorable terms with its clearing firm. This resulted in ARS retaining a greater share of the commissions it received from clients, a best execution violation. The SEC found that the firm also failed to implement policies and procedures reasonably designed to prevent the best execution violations. To settle the SEC charges, ARS agreed to pay disgorgement of $757,876.88, prejudgment interest of $78,688.57, and a penalty of $175,000. The firm also must engage an independent compliance consultant, and had to consent to a censure and cease-and-desist order.
The second case involved a CEO who also served as Chief Compliance Officer officer, Goelzer, and his Indianapolis-based dually registered firm Goelzer Investment Management (GIM). The SEC found that GIM made misrepresentations in its Form ADV about the process of selecting itself as broker for advisory clients. The SEC found that GIM failed to seek best execution for its clients by neglecting to conduct the comparative analysis of brokerage options described in its Form ADV, and recommended itself as broker for its advisory clients without evaluating other introducing-broker options as the firm represented it would. Goelzer and GIM agreed to pay nearly $500,000 to settle the charges that included GIM paying disgorgement of $309,994, prejudgment interest of $53,799, and a penalty of $100,000. The firm was also required to comply with certain undertakings, including the continued use of a compliance consultant and the separation of its chief compliance officer position from the firm’s business function. Goelzer agreed to pay a $35,000 penalty, and Goelzer and GIM consented to censures and cease-and-desist orders.
What are some of the lessons for advisers and funds engaged in managing potential conflicts related to best execution?
While the SEC provides no specific definition of “best execution,” it has said that managers should seek to execute securities transactions for clients in such a manner that the client’s total cost or net proceeds in each transaction is most favorable under the circumstances. The determinative factor is not necessarily the lowest commission cost, but whether the transaction represents the best qualitative execution for the managed account. So what should advisers learn from these cases?
- Recognize the importance of having strong written policies and procedures that provide guidance concerning the quality of trade execution while, at the same time, attending client investment objectives and constraints.
- Make sure that disclosures in Form ADV and elsewhere include information about trading and actual and potential trading conflicts of interest.
- Document compliance with best execution policies and procedures and disclosures to clients.
- Consider setting up a brokerage or trade management committee to review trade placement and best execution. The committee should address such topics as broker trading cost and execution, brokerage expertise and infrastructure and the broker’s willingness to explore alternative trading options.
- Test for best execution, including possibly hiring a third party service provider to periodically assess the broker’s capacity to evaluate which competing markets, market makers, or electronic communication networks (ECNs) offer the most favorable terms of execution, the speed of execution, and the likelihood that the trade will be executed.
There are numerous sources to consult when thinking about and developing best execution policies. A few advisers might want to consider include: Trade Management Guidelines (Nov. 2002), available at www.dfainstitute.org/standards/ethics/tmg; See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170 (Apr. 23, 1986) (“1986 Soft Dollar Release”); Lori Richards, Valuation, Trading, and Disclosure: The Compliance Imperative, Remarks at the 2001 Mutual Fund Compliance Conference of the Investment Company Institute (June 14, 2001), available at www.sec.gov/news/speech/spch499.htm.
In statements following these cases, the SEC warned all investment advisers with affiliated broker-dealers that it would hold them accountable to ensure clients are obtaining the most beneficial terms reasonably available for their orders.
These enforcement actions also continue to ensnare an array of players in municipal securities transactions, that include underlying obligors, their chief executive officers, national and regional investment banks, the heads of public finance departments at several investment banks, as well as individual investment bankers at various levels of seniority, issuers, issuer officials, financial advisers, attorneys and accountants.
The cases have involved everything from tax or arbitration-driven fraud, pay-to-play and public corruption violations, public pension accounting and disclosure fraud, valuation/pricing issues, and most recently, more offering offering and disclosure fraud, involving misleading statements or omissions in offerings.
Two recent enforcement actions illustrate this trend. The first, SEC v. City of Miami, Florida and Michael Boudreaux, an SEC complaint filed in federal court in Miami alleged that the City of Miami, through its then Budget Director, charged that beginning in 2008, the City and the budget director made materially false and misleading statements and omissions concerning certain interfund transfers in three 2009 bond offerings totaling $153.5 million, as well as in the City’s fiscal year 2007 and 2008 Comprehensive Annual Financial Reports. The City puportedly transferred a total of approximately $37.5 million from its Capital Improvement Fund and a Special Revenue Fund to the General Fund in 2007 and 2008 in order to mask increasing deficits in the General Fund.
The complaint alleged that the City and the budget director failed to disclose to bondholders that the transferred funds included legally restricted dollars which, under Miami’s city code, was not permitted to be commingled with any other funds or revenues of the City. The defendants also failed to disclose that the funds transferred were allocated to specific capital projects which still needed those funds as of the fiscal year end or, in some instances, already spent that money. The transfers enabled the City of Miami to meet or come close to meeting its own requirements relating to General Fund reserve levels. According to the SEC, the results of the transfers, meant that the City’s bond offerings were all rated favorably by credit rating agencies.
The second and most recent case, In The Matter of West Clark Community Schools, a settled administrative cease-and desist proceeding, involved the West Clark Community Schools, an Indiana school district. In 2005, the West Clark Community Schools contractually, in accordance with SEC rules, undertook to annually disclose certain financial information, operating data and event notices in connection with a $52 million municipal bond offering. In 2007, the school district, in connection with a $31 million municipal bond offering, stated in public bond offering documents that it had not failed, in the previous five years, to comply in all material respects with any prior disclosure undertakings. That statement, the SEC alleged, as well as a Certificate and Affidavit signed by the School District attesting that the offering documents did not contain any untrue statement of material fact, was materially false. To the contrary, the SEC found that between at least 2005 and 2010 the School District never submitted any of its contractually required disclosures.
As a result, the SEC claimed that the school district violated Section 17(a)(2) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5(b) thereunder. In a separate, but related, settled cease-and-desist proceeding, In the Matter of City Securities Corporation and Randy G. Ruhl, the SEC found that City Securities, the underwiter, and an vice president of City Securities’ municipal bond department conducted inadequate due diligence and, as a result, failed to form a reasonable basis for believing the truthfulness of material statements in an the school district’s official statement, resulting in City Securities offering and selling municipal securities on the basis of a materially misleading disclosure document.
In addition to being censured, City Securities was ordered to pay disgorgement and civil penalties. The vice president was barred from the securities industry with a right to reapply after one year and ordered to pay disgorgement and civil penalties.
In July 2012, the SEC issued a comprehensive report with recommendations aimed at helping improve the structure and enhance disclosure provided to investors for a municipal securities market that has grown to $3.7 trillion in municipal debt outstanding from a level of $361 Billion in 1981. To that, add potential enforcement actions from the MSRB, states, and other SROs, and there’s little doubt that the enforcement action trend will escalate.
The August 15 deadline for investment advisers to make Form 13F filings to report equity security securities holdings of their managed accounts is approaching. Form 13F must be filed within 45 days of the end of a calendar quarter.
As required by Section 13(f) of the Securities Exchange Act of 1934, and rule 13f-1, Institutional investment managers ( which includes investment advisers) must file Form 13F with the SEC if they exercise investment discretion for accounts holding Section 13(f) securities. Section 13(f) securities are defined in the rules as securities having an aggregate fair market vaule of at least $100 million on the last trading day of any month of any calendar year.
What types of securities are Section 13F securities? The SEC has said that “[s]ection 13(f) securities generally include equity securities that trade on an exchange (including the Nasdaq National Market System), certain equity options and warrants, shares of closed-end investment companies, and certain convertible debt securities. The shares of open-end investment companies (i.e., mutual funds) are not Section 13(f) securities.” Advisers can find Section 13(f) securities on the Official List of Section 13(f) Securities. An updated list of 13(f) securities is published on a quarterly basis.
Advisers can also find valuable information about the filing’s requirements in the Frequently Asked Questions About Form 13F.
The SEC has announced its schedule for the upcoming Compliance Outreach Program regional seminars to be held in Chicago, New York, Atlanta and San Francisco. Investment adviser and investment company senior officers, including chief compliance officers (CCOs) are invited to register and attend. The first meeting will occur in Chicago on August 28.
This years’ Compliance Outreach Program, which started off in Boston in May, will likely include panel discussions with SEC staff from the Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and Division of Enforcement’s Asset Management Unit. Topics will vary depending on location. For example, the Chicago seminar will address traded and non-traded real estate investment trusts, investment companies with special emphasis on alternative investment funds and money market funds, and current enforcement actions in the investment management industry. The New York seminar will focus more on newly registered investment advisers, dual registrants and to investment advisers affiliated broker-dealers, and will topics like the SEC’s examination process, priorities, risk surveillance, and examination selection process.
As we’ve alerted our audience in previous blogs, investment advisers should attend these meetings because “[t]he seminars highlight areas of focus for compliance professionals. They provide an opportunity for the SEC staff to identify common issues found in related examinations or investigations and discuss industry practices, including how compliance professionals have addressed such matters.”
Registration information about the regional seminars is available at: