SEC ANNOUNCES REGIONAL COMPLIANCE OUTREACH SEMINARS

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:

http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539720572#.Uef5kdK1Eec

 

FINRA’s Targeted Examination Letter on Social Media Use

wallpapers-red-bull-s-eye-target-psdgraphics-x-1June 2013,  has seen FINRA publish another targeted examination letter — this time aimed at members and associated persons use of social media.  FINRA uses these letters, primarily, to educate member firms about how it uses targeted exams, known as sweeps, to gather insights on member regulatory responses on emerging issues, and carry out investigations.

Relying on FINRA Rule 2210(c)(6) which subjects member firms’  communications (including electronic)  to periodic spot-check procedures, FINRA’s Advertising Regulation Department is asking firms and their associated persons for information about how they use social media (e.g., Facebook, Twitter, LinkedIn, blogs).  Questions and information requests include:

  • how a firm’s social media (e.g., Facebook, Twitter, LinkedIn, blogs) platform is being used as part of its business purpose; 
  • URL information for all social media sites the firm uses; date of first use, and the identity of those who post or update content;
  • how a firm’s associated persons are using social media;
  • a firm’s written supervisory procedures covering the production, approval and distribution of social media communications;
  • what measures firms adopt to monitor compliance with social media policies (e.g., training meetings, annual certification, technology);
  • a list of a firm’s top 20 producing registered representatives (based on commissioned sales) who used social media for business purposes to interact with retail investors, including the type media they use, their name, CRD number, and dollar amount of sales made and commissions earned during a specific period.

FINRA says its  selection of firms for the targeted exam is based on a number of factors, including the “level and nature of business activity in a particular area, customer complaints and regulatory history, and prior examination findings.”

The letter demonstrates the attention broker-dealer’s should pay to both adopting policies and procedures and supervising interactive electronic communications to ensure that content requirements of FINRA’s communications rules are not violated.  In doing so, members should review FINRA’s Regulatory Notices 07-59, 10-06,  11-39 and FINRA Conduct Rules 2210 and 3010.

 

Regulation S-ID: New Rules For Identity Theft

From Section 1088 of the Dodd-Frank Act comes final rules and guidelines from the SEC that would require entities covered by the rules to establish programs aimed at detecting, preventing, and mitigating identity theft.  Previously, Dodd-Frank required the SEC and the U.S. Commodity Futures Trading Commission (“CFTC”) to adopt joint rules requiring entities that are subject to these agencies’ respective enforcement authorities to address identity theft.

Regulation S-ID  is an expansion of  the initial requirements of  amendments in 2003 to the Fair Credit Reporting Act.  Those amendments  required federal agencies deemed “financial institutions,”  or “creditors” to issue joint rules and regulations regarding identity theft.  The rules were enacted in 2007.  At the time, neither the SEC nor the CFTC adopted the identity theft rules because the laws did not authorize either agency to do so.  Instead, entities that the SEC and CFTC regulate such as broker-dealers and futures commission merchants were covered by the rules of other agencies.  Even though the SEC was not one of the included agencies, many of its regulated entities were likely to have already been subject to similar rules enacted earlier by those other agencies, as a result of activities that cause these entities to qualify as “financial institutions” or “creditors.”

The SEC  rules are similar to those that other agencies adopted in 2007.  The SEC and CFTC rules include guidance to help firms determine how to comply with the new rules.  The SEC’s identity theft rules would apply to broker-dealers, investment companies, and investment advisers.  The CFTC’s rules would apply to entities such as futures commodity merchants, commodity trading advisors, and commodity pool operators.

The final rules note that Rule S-ID will become effective 30 days after its publication in the Federal Register.  The compliance date for the final rules will be six months after their effective date.

 

The Consequences For Untimely Producing Records to Regulators

A recent SEC enforcement case illustrates again how an investment adviser’s  failure to  timely respond to SEC requests for books and records during an inspections and examinations can turn into an enforcement action.  The outcome should not surprise.  With the limited facts available, one wonders why the SEC’s restraint in bringing an action lasted as long as it did.  There are, however, a few important takeaways for advisers and their compliance professionals.

The case, In the Matter of  EM Capital Management, LLC and Seth Richard Freeman,  involves the SEC issuing an order instituting administrative and cease-and-desist proceedings against an adviser and its principal for failing, over a year and a half period, to furnish books and records to the Commission’s Investment Adviser/Investment Company examination staff.  The requested records included financial statements, e-mails, and documents relating to the adviser and a mutual fund it managed.

After repeatedly promising to produce the documents following repeated requests from the examination staff, the adviser ultimately did comply.  However,  by then, presumably, the Commision’s patience had finally worn thin, and the staff notified the adviser and its principal that the SEC was considering enforcement action against him and the firm.

The Commission alleged that the adviser violated, and the principal aided and abetted violations of Section 204 of the Advisers Act and Rule 204-2, thereunder.  These  regulations and rules require SEC-registered investment advisers to produce required books and records to the Commission’s staff. The adviser and principal were censured and jointly ordered to pay a civil penalty of $20,000.

The lessons imparted from this and similar cases brought by the Commission are at least three-fold:

  1. Never refuse to produce documents that are subject to the SEC’s inspection powers. i.e. generally, with a few exceptions, Rule 204-2(e) of the Investment Advisers Act of 1940 (“Advisers Act”) requires advisers to maintain their books and records for at least five years, and maintained in an appropriate office of the adviser for the first two years.
  2. Delaying tactics is not a good idea since it probably raise more red flags for the examination staff that’s some rule violation may have occured.  If  additional time is needed to comply bring requests to the staff’s attention and make sure it and any extensions granted are documented.
  3. Despite the lesser sanctions in this case, advisers and their compliance personnel should never forget that, under Section 217 of the Advisers Act, willful failure to permit the SEC to inspect books and records is a felony, punishable by a fine of not more than $10,000 and imprisonment up to five years or both.
  4. Nothing stated above should suggest that advisers may not seek to limit the scope of books and records sought.  This includes, where appropriate, asserting relevant privileges against producing certain documents, seeking clarifications about unclear or open-ended requests, and objecting to burdensome and unreasonable production.

 

The SEC’s “Presence Exams” letter to Private Fund Advisers

As part of its National Exam Program, the SEC’s Office of Compliance and Examinations (“OCIE”) has just mailed a letter to senior executives and Chief Compliance Officers of newly-registered investment advisers apprising them of what practices they can expect to be examined.  

While the letter primarily concerns risk-based exams of advisers to private funds that registered with the SEC after July 21, 2011, the significance the OCIE examination staff is attaching to certain adviser practices in these so-called “Presence Exams” should be weighed by all advisers regardless  – whether they’re new or a private fund.  As we have discussed these and other areas of exam focus in previous posts, OCIE’s hot areas referenced, and set for review, include:

  1. Marketing materials;
  2. Portfolio management;
  3. Conflicts of interest;
  4. Safety of Client Assets; and
  5. Valuation of Client holdings and assessment of fees based on valuations.

Through the SEC’s lens, each of these topics is being viewed in three phases: engagement; examination; and reporting.  

 

Hedge Funds Should Heed SEC’s Latest Investor Bulletin

Add a few recent SEC actions against hedge funds that include a hedge fund manager running a $37 million Ponzi scheme; a former director in a compensation scheme that netted hundreds of thousands of dollars in undisclosed income; co-founders of a Chicago-area investment firm misleading investors and supervisory failures resulting in penalties of more than $1 million; a private fund manager and his investment advisory firm taking more than $17 million in losses in a Ponzi-like scheme.

And now add to that two even more recent cases: a hedge fund manager over the course of several years invest the majority of a fund’s assets in a private business owned by the manager’s affiliated company; and a manager who used his hedge fund as a ruse to misappropriate over $550,000 from a retired schoolteacher, and you get the math of why SEC hedge fund oversight will continue to intensify.  Given many of the enforcement actions in the past two years are the result of  fairly egregous conduct, the SEC Office of Investor Education and Advocacy’s most recent  Investor Bulletin is still  instructive, not simply for investors, but also, for the hedge funds who serve them.

The bulletin warns investors about continued hedge fund-related misconduct in the markets while mentioning these cases as examples of why investors need to take precaution before making hedge fund investments.  While there’s nothing surprising about precautions and recommendations that include

  •  a need for investors to understand a hedge fund’s investment strategy and its use of leverage and speculative techniques before making the investment;
  • a need for investors to evaluate a hedge fund manager’s potential conflicts of interest and take other steps to research those managing the fund;

the bulletin highlights the need for registered advisers to hedge funds to pay particular attention to conflicts of interest when making investment decisions, particularly when determining how investment opportunities are allocated.  Advisers also have to be wary about engaging in principal transactions when managing hedge funds — for example, engaging in rebalancing or other types of cross trades.  Among others, they should concern themselves with the valuations assigned to particular securities, and calculations of  all fees and other income sources. 

For hedge fund advisers, these bulletins, whose primary aim is educating the investing public, are another way to take a deeper look for potential conflicts that may lead to violations and to understand the emphasis SEC examiners and regulators will place on such conflicts.

SEC Report: Broker-Dealers’ Handling of Material NonPublic Information

The Securities and Exchange Commission, through the Office of Compliance Inspections and Examinations (OCIE), has announced and issued a staff report aimed at aiding broker-dealers in safeguarding confidential information from misuse.

Taken from examinations of broker-dealers conducted by the SEC, FINRA, and the NYSE’s Division of Market Regulation, the report reflects strengths and weaknesses OCIE identified in examining how broker-dealers handle material nonpublic information to prevent improper uses.  Misuses might include insider trading, trading during a tender offer in violation of SEC rules or through issuance of a research report based on  material non-public information.

When facing the challenge of designing their controls, the report may be particularly beneficial to broker-dealers dually-registered as investment advisers or who are closely integrated with an affiliated investment adviser.

Carefully pointing out that no one size fits all, and from a “best practices” perspective, OCIE found two practices among some broker-dealers to be particularly effective. The first involved those included broker-dealers who developed processes that differentiated between types of material non-public information based on the source of information coming from within the broker-dealer or the nature (e.g., transaction type) of the information.  In certain instances, the report notes, ” broker-dealers were creating tailored exception reports that took into account the different characteristics of the information.”

The second practice involves broker-dealers who expanded the scope of instruments that they reviewed for potential material non-public information misuse  by traders.  Included are credit default swaps, equity or total return swaps, loans, components of pooled securities such as unit investment trusts and exchange traded funds, warrants, and bond options.

In addition to defining  many of the sources of material non-public information, the report also provides an overview of broker-dealers’ controls structure and their controls – both in terms of  public versus private side of transactions, and in how firms limit and prevent authorized and unauthorized access (physical and technical barriers) to such information.

A look at SEC litigation releases, in the past few six months alone, show no shortage of cases involving misuse of material nonpublic information being either filed or settled.   As the report states, look for OCIE to continue reviewing broker-dealer practices in these areas in future examinations.

NASAA: 2012 Compliance Best Practices For Broker-Dealers

Using results from problems found during a nationwide examinations of broker-dealers conducted by state securities examiners from 24 North American Securities Administrators Association (NASAA) jurisdictions that revealed significant problems, NASAA  has identified what it believes are top compliance violations and made recommendations to solve them.

With the 2012 Coordinated Broker-Dealer Examinations Project, NASAA addresses problem areas while offering 10 recommended best practices that broker-dealers should consider to improve their compliance practices and procedures.

In its  release, NASAA highlights the project’s finding that “the greatest frequency of violations (29 percent) involved books and records, followed by supervision (27 percent), sales practices (24 percent), registration & licensing (14 percent), and operations (6 percent).”  NASAA found the top five types of violations included “failure to follow written supervisory policies and procedures, suitability, correspondence/e-mail, maintenance of customer account information, and internal audits.”

While these findings and recommendations may prove useful, they should come as no surprise to broker-dealers who, in the past few years, have been examined by either FINRA, the SEC or any state for that matter. 

 

Revenue Sharing Arrangements to Get Heightened SEC Scrutiny

Investment advisers and broker-dealer should be aware that SEC through its Asset Management Unit has commenced an initiative aimed at shedding more light on revenue-sharing arrangements between investment advisers and brokers.

The SEC has announced that it will continue to focus enforcement and examination efforts on uncovering arrangements between advisers and broker-dealers where advisers receive undisclosed compensation and conceal such conflicts of interest from clients.

The Commission recently instituted a settled administrative proceeding against  Focus Point Solutions and The H Group, two Portland, Oregon-based investment advisory firms, and their owner over their failure to disclose to clients a revenue-sharing agreement and other potential conflicts of interest.

The SEC’s investigation found that the two firms and their owner failed to disclose to customers that they were receiving revenue-sharing payments from a brokerage firm that managed a particular category of mutual funds being recommended to Focus Point’s clients.  Since Focus Point received a percentage of every dollar that its clients invested in the mutual funds, there was an incentive to recommend these funds over other investment  opportunities in order to generate additional revenue for the firm.

 As part of the arrangement , the broker agreed to pay Focus Point for all client assets that Focus Point invested in certain mutual funds.  In exchange, Focus Point agreed to provide certain custodial support services to the broker.  The SEC found that the agreement created incentives for Focus Point to favor a particular category of mutual funds over other investments.

 Focus Point also provided misleading information about its fee structure to  trustees of a mutual fund Focus Point for whom was seeking approval to become the sub-adviser.  During the sub-adviser to the fund hiring process,  Focus Point told the trustees that Focus Point would not receive any compensation beyond its sub-advisory fee.  This was not true.  Unbeknownst to the trustees, Focus Point had an arrangement with the fund’s primary adviser whereby the primary adviser would compensate Focus Point.

As part of the SEC’s Order entered in the case, Focus Point, The H Group and its owner were censured and agreed to pay a combined $1.1 million to settle the case.

SEC Issues New Alert on Political Contributions

Political contributions continue to be a primary source of concern for regulators like the SEC and the Municipal Securities Rulemaking Board…….

The SEC has recently issued another Risk Alert concerning Municipal Securities Rulemaking Board’s Rule G-37,  a rule that limits political contributions by municipal securities professionals to campaigns of public officials of issuers whom they do or seek to do business.  Typically, the illegal practice, known as “pay-to-play, involves public officials granting public contracts to their campaign contributors, or contractors, by attempting to influence the award of a contract, making contributions to an official who can influence the contracting process.

In issuing the alert, the SEC’s Office of Compliance Inspections and Examination noted the Commission’s concern with certain practices its examiners in the field have observed that may crossed the line violating the rule.   These so-called “pay to play”practices include:

  • firms that may have engaged in municipal securities business with issuers within two years of  making contributions (other than  de minimis contributions) to officials of the issuer.
  • firms that may not have maintained accurate and complete lists of their municipal financial professionals (MFPs) and non-MFP professional executive officers as required by MSRB Rule G-8.

  • firms that may have failed to file accurate and complete Form G-37s, by  identifiying on the form all municipal securities business that a firm has  engaged or all political contributions made to issuer officials by MFP and non-MFP executive officers.

  • firms that may have failed to create or implement supervisory procedures adequate enough to comply with Rules G-37 and G-38.

In addition to addressing the above issues, for some investment advisers this will mean taking steps to review political contribution reports related to any government client, reviewing any pattern of contributions by certain employee or group of employees, and other relevant factors.  In addition,  any review should  include any known external information, such as public contribution reports required by the MSRB, state and local law in relevant jurisdictions.