An Outline of The SEC’s 2014 Examination Priorities

Last week I wrote about FINRA’s 2014 exam priorities. This week, the SEC announced its 2014 examination priorities covering a number of topics important to investment advisers, investment companies, broker-dealers, clearing agencies, exchanges and other self-regulatory organizations, hedge funds, private equity funds, and transfer agents.

While the SEC makes clear the list is not exhaustive, areas that firms will see heightened scrutiny include fraud detection and prevention, corporate governance and enterprise risk management, technology controls. Included also are issues concerning the growing relationship between broker-dealers and investment advisers, new rules and regulations, and retirement investments and rollovers. Continue reading “An Outline of The SEC’s 2014 Examination Priorities”

FINRA’s 2014 Broker-Dealer Exam Focus

As it does every year since 2006, the FINRA has just released its 2014 Regulatory and Examination Priorities letter  highlighting significant risks and regulatory issues for member firms and how FINRA plans to address such matters in its examination of broker-dealers.  The hope is that broker-dealers will use the letter to identify risk exposures to enhance their supervisory, compliance and risk management programs to protect investors, the integrity of the markets and themselves.  Unfortunately, for some the letter goes unheeded until later the firm is ”shocked” to learn during a FINRA cycle exam that the examination staff is spending so much time reviewing the firm’s records on an issue raised in the letter. Continue reading “FINRA’s 2014 Broker-Dealer Exam Focus”

Reminder: SEC National Compliance Outreach Program

Advisers are reminded the SEC’s annual compliance outreach program National Seminar will be held on January 30, 2014, at its headquarters in Washington, D.C. Investment adviser and investment company senior officers, including chief compliance officers (CCOs) are invited to register and attend.

This year’s agenda 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 and investment adviser personnel. The agenda’s topics will include SEC exam priorities in 2014, private fund advisers, registered investment companies, valuation, and the role of the CCO. Continue reading “Reminder: SEC National Compliance Outreach Program”

Compliance Risks With Leveraged and Inverse ETF Sales

FINRA has ordered Atlanta-based broker-dealer, J.P. Turner & Company, L.L.C. to pay $707,559 in restitution to 84 customers for sales of unsuitable leveraged and inverse exchange-traded funds (ETFs) and for excessive mutual fund switches.

FINRA’s action against J.P. Turner is another reminder of the need for broker-dealers to carefully scrutinize the suitability of such non-conventional investments products like inverse exchange-traded funds.

While FINRA mutual fund switch violation cases (a practice FINRA has addressed repeatedly) are more common, inverse ETFs sales practice violations case have not been as prominent, but should come as no less a surprise. Continue reading “Compliance Risks With Leveraged and Inverse ETF Sales”

More SEC Guidance To Avoid Blowing The Venture Fund Adviser Registration Exemption

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:

Continue reading “More SEC Guidance To Avoid Blowing The Venture Fund Adviser Registration Exemption”

Reminder: Broker-Dealer and Investment Adviser 2014 Renewals

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.

NEW REGISTRATION RULES FOR MUNICIPAL ADVISORS

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.

PRIVATE FUND OFFERINGS: With General Solicitation Relaxation Comes New Scrutiny

 

SearchingWhile under the JOBS Act the capital formation process in private offerings may have gotten easier, the regulatory scrutiny may have gotten harder.

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.

SEC Risk Alert: Business Continuity and Disaster Recovery Planning

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.

SEC Risk Alert: Options Trading That Evades Short-Sale Rule Requirements

risk managementShort sale activity continues to be a significant focus of the SEC, particularly when it involves short sales without delivery, or “failures to deliver.”

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.