On November 3, 2015, an Illinois federal jury convicted Michael Coscia, a high-frequency commodities trader, of six counts of commodities fraud and six counts of spoofing—entering a buy or sell order with the intent to cancel before the order’s execution.1 Coscia’s conviction was the first under the criminal anti-spoofing provisions added to the Commodity Exchange Act (CEA) by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. In the press release touting its victory, the prosecution announced: “The jury’s verdict exemplifies the reason we created the Securities and Commodities Fraud Section in Chicago, which will continue to criminally prosecute these types of violations.” High-frequency traders should take note that the conviction on all six counts of spoofing charged in Coscia’s case may embolden prosecutors across the nation to pursue other spoofing cases with vigor. Given the real possibility of a felony indictment and conviction for spoofing—the latter of which exposes a defendant to imprisonment for up to ten years and significant monetary fines—high-frequency traders should carefully evaluate their strategies and conduct.2
Chair Mary Jo White’s remarks on August 5, 2015 highlighted the SEC’s continuing implementation of the Dodd-Frank Act. Title VII of the Dodd-Frank Act requires the SEC and CFTC to establish a regulatory framework for the over-the-counter swap market. The SEC is specifically tasked with regulating security-based swap (“SBS”) dealers and major participants.
The Dodd-Frank Act added Section 15F to the Exchange Act requiring the SEC to adopt rules to provide for the registration of SBS dealers and major participants. Once registered, SBS dealers and major participants will be required to update information about their business activities, structure, and background in addition to information about affiliates. Moreover, SBS dealers and major participants will be immediately subject to SEC examination and inspection authority upon registration.
Additionally, SBS dealers and major participants are required to perform documented due diligence to ensure there is a framework to enable compliance with federal securities laws. The due diligence will serve as the basis for the senior officer of the SBS dealer or major participant to certify that written policies and procedures reasonably designed to prevent violations of federal securities laws have been implemented at the time of registration.
Under Section 15F(b)(6) it is unlawful, unless otherwise provided by rule, regulation, or order of the SEC, for SBS dealers or major participants to permit a statutorily disqualified associated person to effect or be involved in effecting SBS transactions on their behalf. However, to facilitate the registration process of entities currently engaged in SBS business the SEC provides a limited exception from the statutorily disqualified associated person bar if (1) the associated persons are not natural persons and (2) the statutory disqualifications occurred prior to the compliance date of the final rule once it is published in the Federal Register.
In light of the statutory disqualifications that will apply to dealers and major participants; the SEC has proposed Rule of Practice 194 which provides a process to determine whether it is in the public interest to permit a statutorily disqualified associated person to continue to engage in SBS transactions on behalf of a SBS entity. Comments on proposed Rule of Practice 194 will be due 60 days after it is published in the Federal Register.
Read the SEC release on SBS registration rules HERE.
The Financial Markets Association is hosting its annual Securities Compliance Seminar in Nashville, TN on April 23-25,2014. This seminar is intensive training for intermediate as well as seasoned compliance specialists, internal auditors, attorneys, and regulators that focuses on current compliance topics, new rules or interpretations and regulatory developments, including a Dodd-Frank regulatory update. The seminar gives attendees the opportunity to sharpen their skills through general and breakout sessions. Satisfy CLE/CPE requirements.
Click HERE to view the complete program.
The brochure is also available on FMA’s website, www.fmaweb.org.
Written by: Joseph T. Lynyak, III and Anthony H. Schouten
More than three years following the passage of the Dodd-Frank Act, and intense inter-agency negotiations, the federal financial regulatory agencies collectively adopted the final version of the “Volcker Rule,” or “Rule”—which imposes new and potentially severe limitations on domestic and foreign banking entities’ activities in regard to proprietary trading and investments in “covered funds.” The 72-page final Rule is accompanied by over 800 pages of interpretative guidance, to address more than 1,200 questions that the federal agencies asked commenters to address.
This Alert provides an overview of the principal elements of the Rule and identifies several significant concerns that have already been raised by industry participants. Importantly, we provide our thoughts regarding the process by which banking entities might analyze their current business models and transactional structures, with the goal of avoiding an interruption in deal flow and/or business models by identifying possible coverage by the Rule, as well as adopting modifications to comply with the Rule and prevent or minimize adverse business consequences.
Additional client communications will explore in detail categories of activities and transactions impacted by the Rule, as well as interpretative guidance issued by the federal banking agencies.
Read this article and additional publications at pillsburylaw.com/publications-and-presentations.
Written by: Jessica Brown
On July 25, 2013, the Securities and Exchange Commission’s (“SEC”) Division of Investment Management released its first annual report to Congress, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), regarding how it used private fund data collected from investment advisers on Form PF. Dodd-Frank gave the SEC authority to require registered investment advisers to file reports and maintain records regarding the funds they advise. The SEC adopted Form PF in 2011 as the mechanism through which registered advisers must provide this information to the SEC.
Although it acknowledges that the intent of the Dodd-Frank provision was to provide data for the Financial Stability Oversight Council (“FSOC”) to assess systemic risk, the SEC is using the data to support its own regulatory programs as well.
In this first report to Congress, the SEC indicated that is has been focused on the Form PF electronic filing system, resolving technical issues with security and data collection, guiding Form PF filers through the new form and system, establishing protocols for internal access and protection of data, and providing the FSOC with access to the data. Various divisions of the SEC have begun to use the Form PF data to assist with monitoring, identifying and examining investment advisers and private funds. The SEC also plans to provide non-proprietary Form PF data about large hedge funds to the International Organization of Securities Commission for its report on the global hedge fund market.
Pillsbury and the California Hedge Fund Association invite you to join us on Thursday, April 25, 2013 for an educational program featuring Ms. Jan Lynn Owen, the Commissioner of the California Department of Corporations (DOC) and Person to be Announced from the U.S. Securities and Exchange Commission.
The Commissioner and her staff will discuss the new investment adviser registration rules that were recently adopted by the DOC, including the “exempt reporting adviser” provisions, the interplay between the DOC rules and those of the post-Dodd-Frank rules of the Securities and Exchange Commission.
This program will provide startup hedge fund managers and new investment advisers with the information they need to navigate the registration process, regulatory requirements, and examination focus of the DOC and the SEC, including:
- Eligibility for reliance on the “exempt reporting adviser” provisions and what that means in the registration process
- What the DOC and SEC expect to see in hedge fund manager and investment adviser compliance programs
- Examination and enforcement by the DOC and the SEC and coordination efforts between the two agencies
- Tax planning and compliance for fund managers at the state, local and federal levels
- New DOC and SEC rules in the concept or proposal stage aimed at investment advisers
Date & Time
3:30 pm – 4:00 pm PT
4:00 pm – 4:30 pm PT
Keynote: Jan Lynn Owen
4:30 pm – 5:45 pm PT
5:45 pm – 7:30 pm PT
Pillsbury’s San Francisco Office
Four Embarcadero Center
San Francisco, CA 94111
Jan Lynn Owen, Commissioner, California Department of Corporations
Host and Moderator
Jay B. Gould, Partner, Pillsbury
Jerry Twomey, Deputy Commissioner, Division of Securities Regulation, California Department of Corporations
Doug Bramhall, Tax Managing Director, KPMG
Kristin A. Snyder, Associate Regional Director–Examinations, Securities and Exchange Commission, San Francisco Regional Office
Written by: G. Derek Andreson, James L. Kelly, Christopher M. Zochowski, Marc H. Axelbaum and Ryan R. Sparacino
This article was also published in Law360.
Until a few years ago, private equity firms enjoyed relative insulation from regulatory scrutiny of overseas acquisitions and the operations of multi-national portfolio companies. No longer is that the case. Spurred by the unfounded belief that PE firms are not invested in compliance or the conduct of their portfolio companies, the DOJ and SEC are now training their attention on how PE firms exert oversight and control over their portfolios, with a particular emphasis on FCPA issues. PE firms should prepare for this new scrutiny by taking proactive measures to demonstrate both their awareness and their commitment to earning profits on a level playing field. Most importantly, PE firms must recognize that these efforts are not about appeasing regulators, but go directly to maximizing return on investment.
It’s About Deal Risk, Not Legal Risk
A private equity firm’s foreign investments carry unique risks in the anti-corruption world: the firm may have exposure to substantial fines, penalties and reputational harm through the conduct of a portfolio company, even though the firm maintains only partial control.
This risk arises not only in the context of acquisitions, but also in strategic combinations such as joint ventures. And under successor liability principles, the conduct at issue may have occurred years before the firm considered taking a stake in the company or venture.
These risks permeate the deal cycle, including the exit phase. A sophisticated buyer in today’s market will take a hard look at a target’s anti-corruption compliance. If the compliance program falls short of industry standards, that fact may persuade the buyer to look for other opportunities, or it may convey additional leverage in negotiations.
On February 21, 2013, the Staff of the Securities and Exchange Commission (the “Staff” and the “SEC,” respectively) published its 2013 priorities for the National Examination Program (“NEP”) in order to provide registrants with the opportunity to bring their organizations into compliance with the areas that are perceived by the Staff to have heightened risk. The NEP examines all regulated entities, such as investment advisers and investment companies, broker dealers, transfer agents and self-regulatory organizations, and exchanges. This article will focus only on the NEP priorities pertaining to the investment advisers and investment companies program (“IA-ICs”)
As a general matter, the Staff is concerned with fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and the use and implications of technology. The 2013 NEP priorities, viewed in tandem with the “Presence Exam” initiative that was announced by the SEC in October 2012, makes it abundantly clear that the Staff will focus on the approximately 2000 investment advisers that are newly registered as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”).
The Staff intends to focus its attention on the areas set forth below.
New and Emerging Issues.
The Staff believes that new and emerging risks related to IA-ICs include the following:
- New Registrants. The vast majority of the approximately 2,000 new investment adviser registrants are advisers to hedge funds or private equity funds that have never been registered, regulated, or examined by the SEC. The Presence Exam initiative, which is a coordinated national examination initiative, is designed to establish a meaningful “presence” with these newly registered advisers. The Presence Exam initiative is expected to operate for approximately two years and consists of four phases: (i) engagement with the new registrants; (ii) examination of a substantial percentage of the new registrants; (iii) analysis of the examination findings; and (iv) preparation of a report to the industry on the findings. The Presence Exam initiative will not preclude the SEC from bringing enforcement actions against newly registered advisers. The Staff will give a higher priority to private fund advisers that it believes present a greater risk to investors relative to the rest of the registrant population or where there are indicia of fraud or other serious wrongdoing. We expect to see the SEC bring enforcement actions against private equity and hedge fund managers for issues related to valuations, calculation of performance-related compensation and communications to investors that describe valuations and performance-related compensation.
- Dually Registered IA/BD. Due to the continued convergence in the investment adviser and broker-dealer industry, the Staff will continue to expand coordinated and joint examinations with the broker dealer examination program of dually registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals. It is not uncommon for a financial professional to conduct a brokerage business through a registered broker-dealer that the financial professional does not own or control and to conduct investment advisory business through a registered investment adviser that the financial professional owns and controls, but that is not overseen by the broker-dealer. This business model presents many potential conflicts of interest. Among other things, the Staff will review how financial professionals and firms satisfy their suitability obligations when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed.
- “Alternative” Investment Companies. The NEP will also focus on the growing use of alternative and hedge fund investment strategies in registered open-end funds, exchange-traded funds (“ETFs”), and variable annuity structures. The Staff intends to assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.
- Payments for Distribution In Disguise. The Staff will also examine the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same. With respect to private funds, the Staff will examine payments to finders or other unregistered intermediaries that may be conducting a broker dealer business without being registered as such. Payments made pursuant to the Cash Solicitation Rule will also be a focus of private fund payment arrangements.
The Staff anticipates that the ongoing risks selected as focus areas for IA-ICs in 2013 will include:
- Safety of Assets. The Staff has indicated that recent examinations of investment advisers have found a high frequency of issues regarding the custody and safety of client assets under the Investment Advisers Act of 1940 (“Advisers Act”) Rule 206(4)-2 (the “Custody Rule”). The staff will focus on issues such as whether advisers are: (i) appropriately recognizing situations in which they have custody as defined in the Custody Rule; (ii) complying with the Custody Rule’s “surprise exam” requirement; (iii) satisfying the Custody Rule’s “qualified custodian” provision; and (iv) following the terms of the exception to the independent verification requirements for pooled investment vehicles. Many private equity funds and fund of funds have been slow to adopt policies and procedures that comply with the Custody Rule.
- Conflicts of Interest Related to Compensation Arrangements. The Staff expects to review financial and other records to identify undisclosed compensation arrangements and the conflicts of interest that they present. These activities may include undisclosed fee or solicitation arrangements, referral arrangements (particularly to affiliated entities), and receipt of payment for services allegedly provided to third parties. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms. Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients. These types of compensation arrangements are commonplace among private equity fund advisers, many of which have just recently registered. In fact, many private equity funds have compensation arrangements that the Staff believes requires broker dealer registration. We believe that the Staff will make this point quite clearly by bringing enforcement actions against certain private equity fund general partners for engaging in unregistered broker dealer activity. Enforcement actions are viewed as an effective way to get the message across to an industry that has long ignored this particular issue.
- Marketing/Performance. Marketing and performance advertising is viewed by the Staff as an inherently high-risk area, particularly among private funds that are not necessarily subject to an industry standard for the calculation of investment returns. Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices. The Staff will also focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures and compliance with record keeping requirements. The Staff is starting to think about how the anticipated changes in advertising practices related to the JOBS Act will affect their reviews regarding registrants’ use of general solicitations to promote private funds. Whether private funds will be permitted to advertise performance under the JOBS Act rules remains to be seen. Certainly, there have been loud and influential voices that advocated for the position that the SEC should continue to study performance advertising by private funds before allowing it in the adoption of the highly anticipated rules.
- Conflicts of Interest Related to Allocation of Investment Opportunities. Advisers managing accounts that do not pay performance fees (e.g., most mutual funds), side-by-side with accounts that pay performance-based fees (e.g., most hedge funds) face potential conflicts of interest. The Staff will attempt to verify that the registrant has controls in place to monitor the side-by-side management of its performance-based fee accounts and non-performance-based fee accounts with similar investment objectives, especially if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts or funds. For certain types of strategies, such as credit strategies, where one fund may be permitted to invest in all securities in the capital structure, whereas other funds may be limited in what they can purchase by credit quality or otherwise, these potential conflicts of interest are particularly acute. Fund managers must have policies in place that account for these potential conflicts, manage the conflicts and document the investment resolution.
- Fund Governance. The Staff will continue to focus on the “tone at the top” when assessing compliance programs. The Staff will seek to confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability. Chief Compliance Officers will want to make sure that those items that are required to be undertaken in the compliance manual actually occur as stated and scheduled.
The staff anticipates that the policy topics for IA-ICs will include:
- Money Market Funds. The SEC continues to delude itself regarding the regulation of money market funds. This once sleepy and relatively benign product is now the pillar of the commercial paper market and functions like and deserves the regulation of a banking product. But the SEC, and the mutual fund trade organization, are loathe to cede authority to banking regulators for this “dollar per share” product. Accordingly, the SEC will continue to try to find ways for thinly capitalized advisers to offer and manage money market funds by requiring money market funds to periodically stress test their ability to maintain a stable share price based on hypothetical events, such as changes in short-term interest rates, increased redemptions, downgrades and defaults, and changes in spreads from selected benchmarks (i.e., basically, all of the market events that have proven fatal to money market funds in the past and which will be so again as long as these funds remain fundamentally flawed).
- Compliance with Exemptive Orders. The staff will focus on compliance with previously granted exemptive orders, such as those related to registered closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds. Exemptive orders are typically granted pursuant to a number of well-developed conditions with which the registrant promises to adhere. The market timing and late trading scandals of 2003 illustrated that once a registrant has obtained an exemptive order, it may or may not abide by all of the conditions of that order.
- Compliance with the Pay to Play Rule. To prevent advisers from obtaining business from government entities in return for political “contributions” (i.e., engaging in pay to play practices), the SEC recently adopted and subsequently amended, a pay to play rule. The Staff will review for compliance in this area, as well as assess the practical application of the rule. Advisers should be aware that most states have their own pay to play rules and many of them have penalties that are far more onerous than the SEC’s rule.
We will continue to monitor this and other new developments and provide our clients with up to date analysis of the rules and regulations that may affect their businesses.
Pillsbury will be hosting back-to-back programs this month on compliance and regulatory challenges facing Chief Compliance Officers. The first program will be held on February 27, 2013 at Pillsbury’s San Francisco office. The second program will be held on February 28, 2013 at Pillsbury’s Los Angeles office. Each program will begin with a brief overview of the recent trend involving the SEC’s referral of enforcement matters against fund managers to the U.S. Department of Justice for criminal prosecution, which will be followed by a panel discussion on the following topics:
- Common compliance deficiencies and other “hot button” issues for SEC examiners
- The use of technology and service providers to simplify Chief Compliance Officers’ obligations and minimize liability
- Best practices in implementing a Code of Ethics (COE), including what should be in the COE and how employee activity should be monitored
- The implications of the U.S. Jumpstart Our Business Startups Act (JOBS Act) on compliance procedures and policies
We hope you can join us.
To register for the San Francisco office event, please click HERE.
To register for the Los Angeles office event, please click HERE.
San Francisco Corporate & Securities partner Jay Gould is quoted in Compliance Week on new investor accreditation practices associated with the JOBS Act.
JOBS Act Puts Spotlight on Investor Accreditation Practices
January 23, 2013
When the Jumpstart Our Business Startups Act, known as the JOBS Act, was enacted last year, a key piece was eliminating solicitation and advertising restrictions on hedge funds and private securities offerings.
Jay Gould, a partner with the law firm Pillsbury Winthrop Shaw Pittman, says the renewed focus on investor accreditation follows years of the private fund industry sliding into a mere cursory “check-the-box” approach. While 20-30 years ago, thorough pre-evaluation of clients or targeting only those with pre-existing relationships was the norm, more recent years have seen evaluation standards decline. “When hedge funds really proliferated in the last 15 years or so, a lot of that stuff just didn’t get done any more,” he says.
Instead, funds began to rely primarily on the representations in subscription agreements. “You sent out a questionnaire, people answered the questions, and unless the guy was pushing a Safeway cart down skid row there was really no reason to think he or she was not an accredited person or a qualified client.”
The requirement of having a pre-existing substantial relationship with the investor similarly fell by the wayside or became loosely interpreted, all under the blinking eyes of regulators. Brazen fund managers even began to brag openly that “nobody checks this stuff any way” and “nobody really knows if anyone is accredited.”
A few years ago, such talk began to wake up regulators, who then began to once again pay more attention to procedures for verification, Gould says. By the time the JOBS Act was enacted last April it became clear that these laissez faire approaches were coming to an end.
At the time, Gould expected that the Commission would go back to some of these old standards of requiring a balance sheet or income statement, or some kind of independent verification. “But they really didn’t do that in the rule,” he says. “They just said it is mushy, so if somebody has a job where it is obvious they make $200,000 a year then you can rely on that, or you can outsource it, or rely on third parties. You just have to come up with something that makes sense for you.”
This has led to considerable debate about whether a principle-based approach is preferable to having hard-and-fast rules. Some contend that issuers want clear-cut rules “so they know how to avoid them,” says Gould.