Articles Tagged with SEC

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(This article was published in the first February 2016 issue of “The Review of Securities and Commodities Regulation” and is reprinted here with permission.)

The last half of 2015 has been characterized by a lot of debate and press attention on the role of the Chief Compliance Officer (“CCO”) at investment advisers. It has attracted attention within the highest levels at the SEC as reflected in a series of public statements and speeches, including the public disagreement of two Commissioners on whether or not there is a new trend targeting CCOs. While this debate has been unusual, it has led to a healthy and productive discussion about the CCO’s role. Below, we will discuss in turn: (a) recent statements over the past six months by SEC leaders about CCOs and whether or not there is a new trend targeting them, (b) what qualities are essential to an effective CCO and whether or not the job should be outsourced, and (c) how an effective compliance leader can prevent and detect any problems and be truly effective in preparing the firm for SEC examinations.

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On January 11, the Office of Compliance Inspections and Examinations (OCIE) of the SEC announced its 2016 Examination Priorities (“Priorities”). To promote compliance, prevent fraud and identify market risk, OCIE examines investment advisers, investment companies, broker-dealers, municipal advisors, transfer agents, clearing agencies, and other regulated entities. In 2016, OCIE will continue to rely on the SEC’s sophisticated data analytics tools to identify potential illegal activity.

This year, private fund advisers should pay attention to the following OCIE Priorities:

  • Side-by-side management of performance-based and asset-based fee accounts: controls and disclosure related to fees and expenses
  • Cybersecurity: testing and assessments of firms’ implementation of procedures and controls
  • High frequency trading: excessive or inappropriate trading
  • Liquidity controls: potentially illiquid fixed income securities – focus on controls over market risk management, valuation, liquidity management, trading activities
  • Marketing / Advertisements: new, complex, and high risk products, including potential breaches of fiduciary obligations
  • Compliance controls: focus on repeat offenders and those with disciplined employees

Highlights for other market participants:

  • Never-Before-Examined Investment Advisers and Investment Companies: focused, risk-based examinations will continue
  • Broker-Dealers:
    • Marketing / Advertisements: new, complex, and high risk products and related sales practices, including potential suitability issues
    • Fee selection / Reverse Churning: multiple fee arrangements – recommendations of account types, including suitability, fees charged, services provided, and disclosures
    • Market Manipulation: pump and dump; OTC quotes; excessive trading
    • Cybersecurity: testing and assessments of firms’ implementation of procedures and controls
    • Anti-Money Laundering: missed SARs filings; adequacy of independent testing; terrorist financing risks
    • Registered representatives in branch offices – focus on inappropriate trading
    • Retirement Accounts: suitability, conflicts of interest, supervision and compliance controls, and marketing and disclosure practices
  • Public Pension Advisers: pay to play, gifts and entertainment
  • Mutual Funds and ETFs: liquidity controls – potentially illiquid fixed income securities
  • Immigrant Investor Program: Regulation D and other private placement compliance

For additional details, visit the SEC’s Examination Priorities for 2016. Please call an Investment Funds and Investment Management Attorney to discuss your firm’s risk areas.

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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

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Read this article and additional publications at pillsburylaw.com/publications-and-presentations.  You can also download a copy of the Client Alert.

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On November 18, 2015, the staff from the U.S. Commodity Futures Trading Commission’s (“CFTC”) Division of Swap Dealer and Intermediary Oversight issued a swap dealer de minimis exception preliminary report (“Preliminary Report”).

The Preliminary Report was issued pursuant to the SEC and CFTC joint regulation defining the term “swap dealer” and providing for a de minimis exception to the swap dealer definition. Under the regulation, a person shall not be deemed to be a swap dealer unless its swap dealing activity exceeds an aggregate gross notional amount threshold of $3 billion (measured over the prior 12-month period), subject to a phase-in period during which the gross notional amount threshold is set at $8 billion. Under the terms of the regulation, the phase-in period will terminate on December 31, 2017, and the de minimis threshold will fall to $3 billion, unless the CFTC sets a different termination date for the phase-in period or modifies the de minimis exception.

The Preliminary Report discusses:

  • Relevant statutory and regulatory provisions defining the term “swap dealer” and implementing the de minimis exception.
  • Data considered in preparing the Preliminary Report.
  • Policies underlying swap dealer registration and regulation and the de minimis exception that form the basis for evaluating the swap market data.
  • Data in light of alternative approaches to a de minimis exception.

Comments on the Preliminary Report must be submitted on or before January 19, 2016 and may be submitted electronically via the CFTC’s Comment Online Process. The staff will complete and publish for public comment a final report after considering the comments it receives on the Preliminary Report.

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The Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) released a “Risk Alert” on November 9, 2015, the purpose of which is to raise awareness of compliance issues observed in connection with the examination of registered investment advisers and investment companies that outsource their Chief Compliance Officers (“CCO”) to unaffiliated third parties.

We encourage our registered investment adviser clients, including hedge fund and private equity managers, that have outsourced their firm’s CCO function to compliance service providers or other third parties to carefully review the following SEC risk alert summary and review their outsourcing arrangement in view of the SEC’s observations.

Outsourced CCO Initiative

The OCIE staff (the “staff”) conducted 20 examinations as part of an Outsourced CCO Initiative to evaluate the effectiveness of compliance programs and outsourced CCOs by considering a number of factors such as:

  • Whether the CCOs appropriately identified, mitigated, and managed compliance risk;
  • Whether the compliance program was designed to reasonably prevent, detect and remedy violations of federal securities laws;
  • Whether there was open communication between those with compliance responsibilities and service providers;
  • Whether the CCOs have authority to influence compliance policies and procedures of the registrants and had sufficient resources to carry out their responsibilities; and
  • Whether compliance was an important part of the registrants’ culture.

Observations of successfully outsourced CCOs

The staff observed compliance strength in outsourced CCOs with the following characteristics:

  • Regular and often in-person communication between the CCOs and registrants;
  • Strong relationships between the CCOs and registrants;
  • Registrants’ support of the CCOs;
  • CCOs having independent access to documents and information; and
  • CCOs having knowledge of the registrants’ business and regulatory requirements.

Observations of unsuccessfully outsourced CCOs

The staff observed compliance weakness in outsourced CCOs with the following characteristics:

  • CCOs providing compliance manuals based on templates not tailored to the registrants’ businesses and containing inappropriate policies and procedures;
  • CCOs visiting registrants’ offices infrequently, conducting limited annual reviews of documents or insufficient evaluation and assessment of training pertaining to compliance matters;
  • CCOs not performing critical control testing procedures and lacking documentation to evidence testing of control procedures;
  • Critical areas of the registrants’ operations were not identified by CCOs resulting in certain compliance policies and procedures not being adopted, including those necessary to address conflicts of interest;
  • CCOs using generic checklists to gather pertinent information regarding the registrants;
  • Registrants providing incorrect or inconsistent information to the CCOs about firm business practices;
  • Lack of follow-up by CCOs with registrants to resolve discrepancies; and
  • CCOs having limited authority within the registrants’ organizations to improve adherence to compliance policies and procedures and implement necessary changes in disclosure practices, such as fees, expenses and other areas of client interest.

Conclusion

The staff reminds registrants that CCOs, whether direct employees, contractors or consultants, must have sufficient knowledge and authority to fulfill their role. In addition, each registrant is responsible for the adoption and implementation of its compliance program and accountable for any deficiencies.

Finally, the staff emphasizes that all registrants, and especially those that use outsourced CCOs, may find the issues identified in the Risk Alert useful to evaluate whether (i) their business and compliance risks have been appropriately identified (ii) policies and procedures are tailored to the specific risks their businesses encounter and (iii) their respective CCOs have the necessary power to effectively perform their responsibilities. Registrants and their funds are advised to review their business practices regularly to determine whether the practices are consistent with compliance obligations under Rule 206(4)-7 under the Investment Advisers Act of 1940 and Rule 38a-1 under the Investment Company Act of 1940.

Please contact the Investment Funds and Investment Management Group if you would like to discuss the SEC alert or need help reviewing your outsourcing arrangement.

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The SEC’s final crowdfunding rules, which are largely consistent with the proposed rules, provide broader access to capital for startups and small businesses, though concerns over cumbersome disclosure and regulatory requirements persist.

On October 30, 2015, the Securities and Exchange Commission (SEC) voted to adopt final rules implementing Title III of the Jumpstart Our Business Startups Act (JOBS Act), known as “crowdfunding”. The final rules, to be codified as “Regulation Crowdfunding” in furtherance of Section 4(a)(6) of the Securities Act of 1933, are expected to become effective in May 2016. A copy of the final rules can be found here.

Regulation Crowdfunding will allow smaller, non-public U.S. companies to raise up to $1 million in any 12-month period by selling securities over the Internet (including through apps and other technologies) to individual investors who are not required to meet any sophistication or wealth standards, but will be subject to relatively small investment limits.

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Read this article and additional publications at pillsburylaw.com/publications-and-presentations.  You can also download a copy of the Client Alert.

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On November 3, 2015, the Securities and Exchange Commission (SEC) announced that Fenway Partners, LLC (Fenway Partners), a private equity fund adviser, agreed to pay more than $10 million to settle charges that it failed to disclose conflicts of interest to a fund client and omitted material facts to investors.

SEC Findings

Fenway Partner’s current and former principals as well as the chief financial officer did not:

  • Disclose to Fenway Capital Partners Fund III, L.P. (the Fund) or its investors that Fenway Partners caused certain portfolio companies of the Fund to cancel management services agreements—subject to management fee offsets—between Fenway Partners and portfolio companies.
  • Disclose to the Fund or its investors the creation of the affiliated entity Fenway Consulting Partners, LLC (Fenway Consulting).
  • Disclose to the Fund or its investors that Fenway Consulting received $5.74 million for providing services to portfolio companies similar to those previously provided by Fenway Partners and often using the same employees—without a management fee offset against the fees paid to Fenway Partners.
  • Disclose in its capital call notice to investors in connection with a portfolio company investment that $1 million of the $4 million total capital call would be used to pay Fenway Consulting fees.
  • Disclose to the advisory board or the investors the conflict of interest concerning cash incentive plan payments to current and former Fenway Partner principals.
  • Disclose, as related party transactions, in the financial statements provided to investors, those payments received by Fenway Consulting for its services to portfolio companies.

The press release is available HERE.

A full copy of the SEC order is available HERE.

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On October 30, 2015, the Securities and Exchange Commission (SEC) adopted Regulation Crowdfunding. The final rule permits companies to offer and sell securities through crowdfunding. The “Regulation Crowdfunding Exemption” is created under Section 4(a)(6), Title III of the JOBS Act.

The key features of the final rules

  1. Permit individuals to purchase securities in crowdfunding offerings subject to certain limits:
    • A company is permitted to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.
    • Individuals are permitted, over a 12-month period, to invest in the aggregate across all crowdfunding offerings up to:
      • The greater of $2,000 or 5% of the lesser of their annual income or net worth, if either their annual income or net worth is less than $100,000.
      • 10% of the lesser of their annual income or net worth, if both their annual income and net worth are equal to or more than $100,000.
    • The aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.
  1. Require companies to disclose certain information about their business and securities offering and to file an annual report with the SEC and provide it to investors.
  2. Create regulatory framework for the broker-dealers and funding portals that facilitate the crowdfunding transactions. A funding portal is required to register with the SEC and become a FINRA member. A company relying on the Regulation Crowdfunding Exemption is required to conduct its offering exclusively through one intermediary platform at a time.

In addition, the SEC is proposing to amend the existing Securities Act Rule 147 and Rule 504. Rule 147 would be amended to, among other things, permit companies to raise money from investors within their state (intrastate offering) without registering the offers and sales with the SEC. Rule 504 would be amended to increase the aggregate amount of securities that may be offered and sold in any 12-month period from $1 million to $5 million. Bad actor disqualification would also apply in Rule 504 offerings.

A full copy of the final rules is available HERE.

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Strategy shifts now the focus, the SEC extracts another pound of flesh from a fund adviser. In a recently settled administrative proceeding, UBS agreed to return $8.2 million of advisory fees to investors, compensate investors for $4.9 million of investment losses and pay $4.4 million in interest and penalties to the SEC for allegedly failing to disclose an investment strategy shift and failing to supervise disclosures. UBS neither admitted nor denied culpability.

Investment advisers are advised to periodically review the description of their strategy and adjust the disclosure if their practices materially diverge from the described strategy over time. In addition, advisers should consider what manner of disclosure is appropriate in light of the facts and circumstances of a major strategy shift – whether, for example, to disclose promptly in an investor letter, prior to the strategy shift with an opportunity to redeem, and whether and when to involve the board of directors and/or outside counsel.

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The SEC, again, makes it clear:  all aspects of fee, expense and other arrangements must be disclosed accurately and in detail before commitments are accepted.

The SEC recently announced a settlement with three investment advisor affiliates of The Blackstone Group (the Advisors) that were accused of breaching their fiduciary duty to funds they manage or managed, failing to make necessary disclosure to the funds’ investors and failing to adopt and implement policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 and its rules. The charges leveled against the Advisors centered on conflicts of interest involving monitoring fees and legal fee discounts. At the time the alleged violations occurred, each of the Advisors was an SEC-registered investment advisor. Although the Advisors neither admitted nor denied the SEC’s findings, they made several changes to existing business practices, agreed to pay the SEC a $10 million penalty and agreed to remit to their funds fees and interest approximating $29 million in response to allegations of violations of Section 206(2) and Section 206(4) of the Investment Advisers Act and Rules 206(4)-8 and 206(4)-7 thereunder.

Accelerated Monitoring Fees

According to the SEC, the Advisors entered into monitoring agreements with each portfolio company owned by their funds and received, in addition to the annual management fees paid by their funds, monitoring fees from the portfolio companies. In accordance with the funds’ limited partnership agreements, fifty percent of the Advisors’ monitoring fees was used to offset the annual management fee otherwise payable by the funds. Under certain of the monitoring agreements, in the event of a private sale or initial public offering of a portfolio company, monitoring fees could be accelerated for the remaining years of the agreements’ terms (including extension periods), discounted to present value and paid in advance upon termination of the agreements. Notwithstanding that fifty percent of the accelerated monitoring fees inured to the benefit of the funds and their limited partners, the SEC found the arrangements problematic because the value of the funds’ assets was reduced by the net amount of the accelerated monitoring fee payments when the portfolio companies were sold or taken public, thereby reducing amounts available for distribution to the limited partners.

The SEC was particularly offended by the fact that, in certain instances, fees were accelerated beyond the period during which a fund owned the relevant portfolio company or beyond the period during which services were performed by the Advisors. In addition, the SEC alleged that, although the Advisors disclosed their ability to collect monitoring fees to the funds and the funds’ limited partners before capital was committed to the funds, the Advisors did not disclose the practice of accelerating monitoring fees prior to the time the Advisors received the accelerated fees. The SEC conceded, however, that monitoring fee acceleration was disclosed in distribution notices, quarterly management fee reports and, where there were public offerings of portfolio companies, in SEC filings on Form S-1. The SEC further acknowledged that the funds’ limited partner advisory committees could have objected to acceleration and arbitrated the matter, but never took such action. The problem, according to the SEC, is that, because of the conflict of interest, the Advisors could not effectively consent to the acceleration.

Disparate Discounts on Legal Fees

The Advisors also negotiated a single agreement with legal counsel pursuant to which legal counsel provided services to the funds and the Advisors.  According to the SEC, although the funds generated significantly more work than the Advisors, the Advisors received substantially greater discounts than the funds. In addition, the difference in the discounts was not disclosed to the funds, the funds’ advisory committees or limited partners. Again, because of the conflict, the Advisors could not consent effectively.

Takeaways

The findings made and penalties imposed by the SEC in the Blackstone matter highlight the SEC’s disdain of conflicts of interest between advisors and the private funds they manage. More importantly, the matter makes clear the SEC’s intention to go after even the most common business practices in private equity, if the SEC determines that aspects of those practices are not disclosed fully prior to the time capital commitments are accepted. Nothing is sacrosanct.

As was the case with Blackstone, a fund’s private placement memorandum typically discloses that the fund’s management entities and affiliates of those entities may receive fees to which the fund will not be entitled. It also customarily discloses actual and potential conflicts involving fund counsel. The SEC has made clear that those disclosures will not be sufficient if they do not describe all aspects of the relevant conflicts clearly, accurately and completely. Broad and generalized disclosures, even where sophisticated and experienced fund investors are able to discern the nature of the conflict, will not protect against violations of Sections 206(2) and 206(4) of the Investment Advisers Act and the rules promulgated under those sections of the Act. Further, disclosures made after investors’ capital commitments are accepted may not be sufficient.

This case also highlights the fact that the SEC will push back against attempts by an SEC-registered investment advisor to limit its fiduciary duty to the funds it advises. In addition, it appears that the SEC will apply Section 206(2) and Section 206(4) of the Investment Advisers Act broadly and with a big stick.

As is always the case, cooperation with the SEC in connection with an examination or investigation is critical. In addition, as is evidenced in the Blackstone matter, taking remedial action to eliminate or ameliorate conflicts can be very helpful to an advisor that is under SEC scrutiny and seeking to minimize exposure to punitive action.