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.

 

Renewal Time: Broker-Dealers, Advisers, Their Agents and Reps

In Regulatory Notice 12-46, FINRA has announced the start of the 2013 Renewal Program for investment advisers, broker-dealers, their agents and investment adviser representatives.  On November 12, 2012, FINRA will make the online Preliminary Renewal Statements available to all firms on Web CRD/IARD. The following dates are key in the renewal process:

  • November 1, 2012     Firms may begin submitting post-dated Form U5,  BR Closing/Withdrawal, BDW and ADV-W filings via Web CRD/IARD.
  • November 12, 2012    Preliminary Renewal Statements are available on Web CRD/IARD.
  • December 13, 2012     Full payment of Preliminary Renewal Statements is due.
  • January 2, 2013          Final Renewal Statements are available on Web CRD/IARD.
  • February 1, 2013        Full payment of Final Renewal Statements is due.

Firms can find guidance in the renewal instructions, the Renewal Program Bulletin, and the IARD Renewal Program Bulletin (if applicable) on the Investment Adviser Registration Depository (IARD) website.

FINRA warns firms that failure to remit full payment of  their Preliminary Renewal Statements to FINRA by December 13, 2012, may cause the firm to become ineligible to do business in the jurisdictions where it is registered, and subject them to late fees effective January 1, 2013.

Compliance Officers and In-house Attorneys Remembering Rule Number One

Back on July 25, 2011, we blogged about the importance attached to chief compliance officers’ understanding the regulatory framework and guiding principles for what it is they do.  As we said then,

“Rule Number One

: Your Job is to “Administer” the Compliance Program: The CCO’s job function as mandated by Rule 206(4)-7 (the “rule”) is limited to “administering” the investment adviser’s compliance policies and procedures. While the rule contains no explicit definition for what the term administering means, the rule makes one thing clear, it is the adviser who is legally required to “adopt and implement written policies and procedures reasonably designed to prevent violation” of the Investment Advisers Act of 1940. What this means is that you are not the guarantor that your adviser will not experience a compliance failure. Nor is it necessarily true, from a supervisory perspective, that you are responsible for the compliance failures of others in the firm. To the contrary, the failure of a compliance program to find and remedy compliance problems can just as easily be viewed as evidence that the adviser’s compliance program, including its policies and procedures, are not effective.

This doesn’t mean that compliance personnel of an adviser can’t be sanctioned for not properly supervising employees. Of course, they can be and are sanctioned. However, the fact that you are a CCO does 

 

not, in and of itself, give you supervisory responsibility over your adviser’s personnel. In short, if you’re not supervising other advisory personnel, and you limit supervisory responsibility to persons who are part of the compliance staff, the Adopting Release to the rule makes clear that you aren’t necessarily liable for the supervisory lapses of your adviser. ……..”

The signficance of this rule is born out in an article appearing in AdviserOne entitled “” makes reference to a report prepared by the law firm of Sutherland Asbill tracking recent regulatory actions involving CCOs and in-house attorneys facing disciplinary actions covering everything from lapses involving  inadequate supervisory systems, anti-money-laundering (AML) compliance program, inadequate due diligence in private offerings, books and records violations to lying to regulators.

Understanding and remembering first what your role is as CCO or in-house counsel may prove to be the only thing separating you and a regulatory sanction.

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.