Time For Quarterly Transaction Reports

FE_DA_Deadline_050613425x283A reminder to advisers,  the code of ethics you adopted probably requires quarterly reports to be prepared for all personal securities transactions made by access persons.  If it doesn’t there are two possible reasons (1) chances are you haven’t read it, or (2) you don’t have one — in which case you need to first read Rule 204A-1 of the Investment Advisers Act of 1940.

The Timing of Transaction Reports

Under Rule 204A-1(b)(2), these reports are due no later than 30 days after the close of the calendar quarter.   Access persons who would be submitting duplicate information contained in trade confirmations or account statements that an  adviser holds in its records (provided the adviser has received those confirmations or statements not later than 30 days after the close of the calendar quarter in which the transaction takes place) may be excused by their investment advisers from submitting transaction reports.

Who is an access person?

Rule 204A-1(e)(1) defines an access person as a supervised person who has access to nonpublic information regarding clients’ purchase or sale of securities, is involved in making securities recommendations to clients or who has access to such recommendations that are nonpublic.  Further, a supervised person who has access to nonpublic information regarding the portfolio holdings of affiliated mutual funds is also an access person, but only to the extent they make, participate in, or obtain information regarding, the purchase and sale of the fund’s securities, or if their functions relate to the making of any recommendations for such transactions.

This definition is broad enough to include, for example,

(i) portfolio management personnel and, in some organizations, client service representatives who communicate investment advice to clients;

(ii)  administrative, technical, and clerical personnel if their functions or duties give them access to nonpublic information;

(iii) organizations where  employees may have broad responsibilities, and fewer information barriers are in place  to prevent access to nonpublic information.  On the other hand, as the SEC has noted, organizations that keep strict controls on sensitive information may have fewer access persons; and

(iv) presumably if the firm’s primary business is providing investment advice, then all of its directors, officers and partners would be access persons.

When must access persons report personal securities transactions?

Under Rule 204A-1(b), each of an adviser’s access persons must report his securities holdings at the time that the person becomes an access person and at least once annually thereafter. Further, they must make to the adviser’s Chief Compliance Officer or other designated person a report at least once quarterly of all personal securities transactions in reportable securities.

What are “reportable securities”?

Rule 204A-1 treats all securities as reportable securities, but list five exceptions designed to exclude securities that appear to present little opportunity for the type of improper trading that the access person reports are designed to uncover. These include transactions and holdings in:

  • direct obligations of the Government of the United States.
  • money market instruments — bankers’ acceptances, bank certificates of deposit, commercial paper, repurchase agreements and other high quality short-term debt instruments.
  • shares of money market funds.
  • shares of other types of mutual funds, unless the adviser or a control affiliate acts as the investment adviser or principal underwriter for the fund.
  • units of a unit investment trust if the unit investment trust is invested exclusively in unaffiliated mutual funds.

There are other exceptions. For example, under Rule 204A-1, no reports are required for transactions effected under an automatic investment plan; No reports are required for securities held in accounts over which the access person has no direct or indirect influence or control; and finally, under Rule 204A-1(d), no report is required in the case of an advisory firm that has only one access person, so long as the firm maintains records of the holdings and transactions that rule 204A-1 would otherwise require be reported.

There are other requirements in Rule 204A-1, the Code of Ethics Rule, covering access persons transactions and holdings that advisers should review.  These includes such issues as pre-approval of certain investments, review of personal holdings and transaction reports, procedures to address personal trading and reporting of violations.

 

 

A Lesson From Ameriprise: Risk Mitigation With Third-Party Prospectus Delivery

Broker-dealers and other financial service firms using third-party service vendors, whether to reduce costs, enhance performance, and obtain access to specific expertise, and perform vital functions, sounds good in most instances.  But doing so is not without risks.

FINRA’s recent disciplinary action against Ameriprise, tagging it with a censure and fine of $525,000, is a reminder of inherent risks when firms fail to monitor outsourced service work to third parties.  In settling with Ameriprise (through an Acceptance Waiver and Consent, FINRA Case # 2011029100301) FINRA found that Ameriprise, in approximately 580,000 transactions, failed to timely deliver mutual fund prospectuses to its customers within three business days of their purchases.  FINRA also found Ameriprise to have failed to establish and maintain adequate supervisory systems and written supervisory procedures that should have reasonably monitored and ensured the timely delivery of mutual fund prospectuses — a requirement of Section 5(b)(2) of the Securities Act of 1933.

As FINRA noted, Rule 10b-10, promulgated under Section 10(b) of the Securities Exchange Act of 1934, requires a broker-dealer to provide to the customer, in writing, certain information “at or before completion of such transaction” and that transactions are complete when they settle.  Rule 15c6-l(a) provides that securities transactions settle in three business days, unless otherwise specified.  Consequently, a broker-dealer must deliver a prospectus to a customer who has purchased a mutual fund no later than three business days after the transaction.

What are the compliance takeaways from the Ameriprise action?  How does a firm avoid or mitigate legal, reputational and operational risks to its business when dealing with outside vendors?

First, firms should make sure they hire qualified vendors and that such relationship are structured to avoid operational problems. Expectations on both sides need to be clearly articulated.  Second,  monitor frequently and document that the outsourced activity is being properly managed.*  Appropriate oversight ensures that the third-party program is meeting its regulatory purpose.  Third, document and make sure that the third-party has adequate internal controls.  Finally, make sure that the vendor has a contingency plan in the event of a disruption, and make sure that you do the same.

In the end, while day-to-day management of a service like sending the prospectus can, in some instances, be transferred to a third party, ultimate responsibility for any compliance requirement cannot be delegated and remains with the financial service firm.

*Outsourcing Financial Services Activities: Industry Practices to Mitigate Risks, Federal Reserve Bank of New York, October 1999, p. 5, available online.; Outsourcing By Financial Services Firms, Broker-Dealer Regulation (Second Edition) Practicing Law Institute, C.E. Kirsch.

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.

 

Is It Okay for Sub-Advisers to Rely on Investment Advisers for Form ADV Delivery?

Can a sub-adviser or unaffiliated adviser, selected by an investment adviser to help manage client assets, deliver its Form ADV Part 2 to the adviser, instead of the client? Yes, they can, according to a recently issued SEC no-action letter  to Goldman, Sachs & Co.

Generally, under Rule 204-3 of the Advisers Act, the “Brochure Rule,” an investment adviser must deliver a copy of its Form ADV (Part 2A) brochure  and any required supplements (Part 2B) to each of its advisory clients or prospective clients before or at the time of entering into an advisory contract with them.  This includes sub-advisers who are required to deliver their own brochure to the advisory client.

Goldman operates discretionary wrap-fee or managed account programs that employ the services of over 40 unaffiliated sub-advisers.  The programs hire and allocate Goldman’s client assets across multiple sub-advisers.  The fact that these sub-advisers managed client assets, establishes a fiduciary relationship with the client, and makes them also responsible for complying with the Brochure Rule.

Goldman sought assurances that permitting clients to elect not to receive the brochure documents but, instead, rely on Goldman to receive them on the client’s behalf would not result in the SEC bringing an enforcement action.In support, Goldman pointed to several examples of so-called “constructive delivery” where the SEC has permitted delivery of documents to a properly authorized agent — thus, constituting delivery to the agent’s principal  in accordance with well-established common-law agency principles.

Examples of  this in other contexts, Goldman noted, included, the SEC permitting investment advisers to receive offering prospectuses on behalf of their clients; the SEC approving various SROs rules allowing broker-dealers to satisfy their proxy delivery obligations, annual and semi-annual reports, and other shareholder communications obligations to customers by sending the materials to the customers’ investment advisers instead of the customers;  under Regulation S-P, the SEC permitting advisers to satisfy their obligations to deliver initial and opt-out notices to consumers by sending the notices to the consumers’ legal representatives; and under rule 206(4)-2, the Custody Rule, the SEC permitting advisers to satisfy their obligations to send notices of custodial arrangements and any required account statements to a client by sending them to an “independent representative” designated by the client.

Investment advisers relying on the Goldman no-action letter should consider implementing, among others, the following  steps:

1.  Offer the client, in writing, the choice of appointing you,  the adviser,  to receive the brochure document from sub-advisers and briefly explain, in plain English, the information in the sub-adviser’s brochure document. This can be done in the investment management agreement or a separate agreement;

2. Inform the client of the identity of any sub-advisers you engage to manage the client’s assets, and inform the client  that allowing you to receive the brochure does not waive or diminish their right to receive the brochure if they so choose;

3. Preserve the brochure documents that you receive and make them available to clients upon request.  Clients should be free to change their minds at any time and request, at no additional cost, that the  sub-advisers’ brochure documents be delivered to them directly;

4. Maintain policies and procedures designed to ensure that the sub-adviser’s brochure documents are appropriately reviewed by the adviser, and ensure that such policies address and manage any conflicts related to any business relationship the adviser has with a sub-adviser; and

5. Finally, when evaluating a particular sub-adviser’s disclosure for material conflicts, consider whether to (a) not retain the sub-adviser or (b) inform affected clients of a specific conflict and seek the client’s consent, even though the client may have elected not to receive brochure documents.

With Settlements, Will the SEC Make Defendants Admit Guilt?

Reporting on Mary Jo White’s speech at a Wall Street CFO Network function, the Washington Post notes her comments about the long-simmering topic of failure of securities law violators to admit guilt when they settle with the SEC.  As a matter of practice, the SEC has routinely allowed defendants to settle cases “without admitting or denying wrongdoing.”  In light of public criticism and some pointed criticisms by judges handling these type settlements(See my December 15, 2011 blog post ), White wants to draw a sharper distinction between those cases where clear-cut misconduct is shown and those cases where wrongdoing or guilt is less clear.

The Washington Post article notes that “[i] an e-mail sent to the SEC staff earlier this week, the co-directors of the enforcement division said that cases in which the defendant engaged in “egregious intentional misconduct” may justify requiring an admission, as would the obstruction of an SEC investigation or “misconduct that harmed large numbers of investors.”

Despite public protestations, and some courts’ misgivings about allowing defendants to pay large fines to settle cases without admitting wrongdoing, wholesale changes in the settlement policy are unlikely.  Further, district courts have limited authority to change an executive branch agency’s decision to settle a claim, including the SEC’s “neither admit nor deny” policy.

Whether a sharper line is drawn or not, such settlements still serve an important public policy.  Similar to the rationale for plea bargaining in criminal cases, without being able to settle without admitting guilt, many defendants would not settle.   Some defendants would rather risk going to trial than admit guilt that might leave them open to other lawsuits, denial of insurance coverage, or higher insurance premiums.  Still other defendants,  lacking resources, might simply consider walking away from these cases.  The result — long investigations and trials with even harsher fines and sanctions that may go uncollected and waste limited resources.

 

Deadline: Financial Statement Distribution for Funds of Hedge Funds

Calendar on desk - June 30thAdvisers to funds of funds who maintain custody of clients funds as defined in Investment Advisers Act Rule 206(4)-2, and whose fiscal year ends December 31,  have a deadline looming.   The deadline is June 30 (180 days of the end of their fiscal year) for distributing to fund investors audited financial statement prepared in accordance with GAAP to fund investors  is approaching.

Normally, for advisers to other pooled investment vehicles, including  limited partnerships and limited liability companies, the deadline for distributing annual audited financial statements  is within 120 days of the end of their fiscal year.  The SEC extended the deadline from 120 days to 180 days for funds of  hedge funds because the earlier deadline made it hard for some fund of hedge funds to timely complete their fund audits prior to audits being completed for the underlying funds in which they invested.

 

Public Arbitrator Definition Excludes Mutual Funds and Hedge Funds

Effective July 1, 2013, add to the types of  individuals who are no longer eligible to serve as public arbitrators in FINRA arbitrations persons associated with, or registered through, a mutual fund or hedge fund.

The list has been growing and already includes  (i) attorneys and accountants who derive a certain percentage or a certain amount of their income from the securities industry, (ii) investment advisers, (iii) persons or spouses employed by entities involved in the securities industry, and (iii) directors or officers or spouses or an immediate family member of a person who is a director or officer of, an entity that directly or indirectly controls, is controlled by, or is under common control with, any partnership, corporation or other organization that is engaged in the securities business.

Despite complaints from some in the securities industry that the change means more arbitrators with less experience and education about how the securitie industry works, the rationale approved by the SEC and adopted under Codes of Arbitration Rules (Customer and Industry Codes) 12100(u)(3) and 13100(u)(3) for including these categories is just the opposite.  The change arises from complaints that certain arbitrators on FINRA’s public arbitrator roster are not perceived as public and may be biased because of their industry background and experience.  The exclusion is not permanent.   If the individual ends the affiliation that was the basis for the exclusion, they are eligible to serve as a public arbitrator  two calendar years after ending the affiliation.

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.

 

SEC 2012 Enforcement Actions Against Investment Professionals

In a press release yesterday, the Securities and Exchange Commission  announced enforcement results for its fiscal year ending September 30, 2012.

The results include the SEC having filed 734 enforcement actions, just one case shy of last year’s record of 735.  According to the Division of Enforcement, the cases,  involved everything from highly complex products, transactions, and practices, including those related to the financial crisis, trading platforms and market structure, to insider trading by market professionals.  In addition, orders were entered in some of these cases requiring the payment of more than $3 billion in penalties and disgorgement for the benefit of investors who were harmed.

Investment Advisers

As for investment advisers, the SEC filed 147 enforcement actions in 2012 against investment advisers and investment companies.  Several cases  resulted from the Division of Investment Management’s investment adviser compliance initiative involving advisers who failed to maintain effective compliance programs designed to prevent securities laws violations.

Other actions involving advisers included the SEC

Broker-Dealers

The Commission filed 134 enforcement actions related to broker-dealers — a 19 percent increase over 2011.  Enforcement actions included an action against a Latvian trader and electronic trading firm for their involvement in an online account intrusion scheme that manipulated the prices of more than 100 NYSE and Nasdaq securities; and an action against New York-based brokerage firm Hold Brothers On-Line Investment Services and three of its executives for allowing overseas traders to access the markets and conduct manipulative trading through accounts the firm controlled.

Municipal Securities

The number of enforcement actions related to municipal securities more than doubled since 2011. The SEC filed 17 actions related to municipal securities, including charging Detroit’s former mayor and treasurer in a pay-to-play scheme involving Detroit’s pension funds.  In another action, the SEC charged Goldman Sachs for violating municipal securities rules resulting from undisclosed “in-kind” non-cash contributions that one of its investment bankers made to a Massachusetts gubernatorial candidate.