SEC Risk Alert: Investment Adviser Compliance Issues Related to the Cash Solicitation Rule

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Risk Alert 

While we were busy handing out candy, the SEC was busy handing out advice! The Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert on October 31, 2018 to provide investment advisers, investors and other market participants with information concerning the most common deficiencies the staff has cited relating to Rule 206(4)-3 (the “Cash Solicitation Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The Risk Alert is intended to assist investment advisers in identifying potential issues and adopting and implementing effective compliance programs, and generally pertains to an adviser’s use of third-party solicitors that are subject to the broader requirements of the Cash Solicitation Rule.

Rule Requirement

Rule 206(4)-3 under the Advisers Act prohibits investment advisers from paying a cash fee, directly or indirectly, to an unrelated third party (a “solicitor”) for referring clients to the adviser unless the arrangement complies with certain conditions, as detailed below:

  • Solicitor agreement: a written agreement is executed between the adviser and the solicitor (a copy of which the adviser must retain) detailing the referral arrangement (e.g., a description of the solicitation activities and compensation to be received, as well as obligations of the solicitor under the arrangement);
  • Adviser’s brochure: at the time of any solicitation activities, the solicitor is required to provide the prospective client with a copy of the investment adviser’s brochure and supplements (i.e., Form ADV Part 2);
  • Solicitor disclosure: at the time of any solicitation activities the solicitor is required to provide a separate and written disclosure document to the prospective client which discloses the solicitor’s relationship to the adviser, and clarifies that the solicitor is being compensated for recommending the adviser, specifying the terms of the compensation arrangement;
  • Client acknowledgement: the adviser receives from the client at a time no later than the execution of the investment adviser’s agreement, a signed and dated acknowledgment that the client received the investment adviser’s brochure and the solicitor’s written disclosure document;
  • Solicitor disqualification: the solicitor may not be a person subject to certain disqualifications specified in the Cash Solicitation Rule; and
  • Compliance: the adviser must make a bona fide effort to ascertain whether the solicitor has complied with the solicitation agreement and must have a reasonable basis for believing that the solicitor has so complied.

Advisers are subject to narrower requirements under the Solicitation Rule when the solicitor is a partner, officer, director, or employee of the adviser or of an entity that controls, is controlled by, or is under common control with the adviser or if the cash fee is paid with respect to solicitation activities for the provision of impersonal advisory services only. The Risk Alert did not enumerate any observed deficiencies related to this type of arrangement.

Recurring Adviser Deficiencies 

The OCIE staff outlined common deficiencies in the Risk Alert, as noted below:

Solicitor disclosure documents: non-provision of disclosure documents to prospective clients pursuant to rule requirement and/or insufficient or obtuse disclosure of required information. Several deficiencies were noted wherein disclosure language regarding compensation were hypothetical or vague. In other situations, disclosure documents failed to clarify that the client would pay a higher fee for advisory services to essentially cover the solicitation fee. The SEC requires all disclosures to be truthful, complete and in Plain English.

Client acknowledgements: untimely or incomplete execution of required client acknowledgments pursuant to rule requirement wherein advisers did not receive a signed and dated client acknowledgement of receipt of the adviser brochure and the solicitor disclosure document. Furthermore, several advisers had received client acknowledgements, but they were undated or dated after the clients had entered into an investment advisory agreement.

Solicitation agreements: advisers paid cash fees to a solicitor without a duly executed solicitation agreement or paid compensation referencing an agreement that did not contain required provisions pursuant to rule requirement.  The SEC determined that solicitors did not perform their duties referenced in the solicitation agreement in a manner consistent with the instructions of the adviser thereby placing the adviser in deficient status.

Bona fide efforts to ascertain solicitor compliance: adviser compliance with rule 206(4)-3 requires advisers to make a genuine effort to ensure that solicitors are complying with cash solicitation rule requirements. The SEC observed that deficient advisers could not represent that they had a reasonable basis to believe that engaged third party solicitors were in full compliance with rule requirements (e.g., there was no evidence of a compliance audit trail with sufficient documentation attesting to solicitor compliance).

Other regulatory implications: the SEC also cited advisers for non-compliance with other provisions of the Advisers Act, e.g., breach of fiduciary duty under Sections 206(1) and 206(2). For example, OCIE observed advisers that recommended service providers to clients in exchange for client referrals without full and fair disclosure of the conflicts of interest.

Action Plan

We recommend that advisers review and amend, as necessary, disclosure documents and solicitation agreements to be consistent with actual practices.  Payment arrangements must be clear to all parties involved, including solicited clients. We also recommend that advisers adopt an internal control whereby the Chief Compliance Officer or designee performs appropriate due diligence for all engaged third party solicitors to ensure that all parties remain compliant with cash solicitation rule requirements. The frequency of review should be commensurate with the level of activity and risks associated with solicitation arrangements. Of course, all due diligence efforts must be documented in writing, and written policies and procedures must be adopted and implemented to ensure full compliance with the rule. Finally, although the SEC did not call out advisers for solicitation arrangement deficiencies evident with related party solicitors, investment advisers must ensure that related party arrangements follow the requirements of Rule 206(4)-3.

The SEC has stated that examinations within the scope of this review resulted in a range of regulatory actions against advisers, including enforcement actions. As one example, the SEC acted against an adviser deemed to violate the Cash Solicitation Rule by paying a cash fee to a solicitor despite knowing that the solicited clients had not received the necessary disclosures.

For More Information 

View the Risk Alert here: Investment Adviser Compliance Issues Related to the Cash Solicitation Rule (PDF)

IM Information Update 2018-02   Statement Regarding Staff Proxy Advisory Letters

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Information Update 

On September 13, 2018, the SEC’s Division of Investment Management issued IM Information Update 2018-02 entitled “Statement Regarding Staff Proxy Advisory Letters.” The purpose of this Update is to notify advisers of its withdrawal of two 2004 no-action letters related to proxy voting. This Update follows the Commission’s July 2018 announcement of its plans to host a Roundtable with market participants (now scheduled for November 2018) to address proxy voting topics including the voting process, retail shareholder participation and the role of proxy advisory firms.

Over the past decade the SEC has consistently conveyed concern in public discourse and in adviser examinations regarding the growing reliance by advisers on proxy consultants. In 2010 the Commission sought public comment on the issue due to concern that the SEC’s own guidance permitted advisers to fulsomely rely upon the recommendations of proxy consultants. After reviewing this condition, the SEC has determined that over-reliance by advisers on proxy consultants may introduce a conflict of interest wherein the investment adviser fiduciary duty to provide objective investment advice is jeopardized.

This determination has resulted in an unusual but by no means unprecedented regulatory intervention wherein the SEC re-examined and subsequently withdrew (effective September 13, 2018) no-action letter guidance addressing adviser proxy voting services. This regulatory guidance was issued to Egan-Jones Proxy Services (May 27, 2004) and Institutional Shareholder Services, Inc. (Sept. 15, 2004). This guidance clarified that voting in reliance on a proxy consultant’s voting recommendations will insulate an investment adviser from any conflicts of interest and otherwise support the discharge of the investment adviser’s fiduciary duties.

However, the Egan Jones letter also issued a warning that the adviser should not conclude that it is appropriate to follow the voting recommendations of an independent proxy voting firm without first ascertaining, among other things, whether the proxy voting firm (a) has the capacity and competency to adequately analyze proxy issues; and (b) can make such recommendations in an impartial manner and in the best interests of the adviser’s clients.

As to the withdrawal of its 2004 no-action letter guidance, the Commission has stated that it has done so to facilitate the forthcoming roundtable discussion wherein the Commission will solicit and consider input from various market participants and stakeholders, i.e., public companies, public funds, investors, proxy advisors, and registered firms, among others, on all matters related to proxy voting.

Staff Legal Bulletin No. 20 (Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms), issued by the Division of Investment Management in June 2014, remains in force, and provides guidance to advisers about their responsibilities in voting client proxies and retaining proxy advisory firms (including a reiteration of the Egan Jones capacity, competency, and impartiality standards).

 

Conclusions

The regulatory regime requires advisers to implement risk-based policy and procedure that is reasonably designed to ensure compliance with securities statutes. The rescindment of the referenced no-action guidance makes this risk management objective more problematic for advisers that retain proxy voting authority.

Advisers that retain voting authority are required to fulfill the fiduciary standard of care when voting proxies, as referenced in the Egan Jones letter. The Commission views proxy voting as a vital component of the investment decision making process. Proxy advice and decisions must be disinterested and objective in nature to ensure that client interests prevail in all voting decisions.

Furthermore, advisers must monitor proxy policies and procedures and fully document and retain all related input utilized to formulate, execute, and assess voting decisions in much the same manner as the adviser does investment decisions for clients.  Legal Bulletin No. 20 provides a helpful Question & Answer format to assist advisers in stress testing their proxy voting policies and procedures.

The proxy consultant industry has grown exponentially since advisers were first required to register with the SEC in 2004. This growth, and adviser reliance upon this industry, exerts considerable pressure upon advisers to evince through documentation that proxy consultants are but one source of input rather than the sole source.

 

Valuable Information Sources 

IM Information Update 2018-02: https://www.sec.gov/divisions/investment/imannouncements/im-info-2018-02.pdf

To view the SEC’s public statement about its actions with regard to the proxy letters, follow this link: https://www.sec.gov/news/public-statement/statement-regarding-staff-proxy-advisory-letters 

Staff Legal Bulletin No. 20 is available here: https://www.sec.gov/interps/legal/cfslb20.htm

OCIE Risk Alert – Compliance Issues Related to Best Execution by Investment Advisers

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Introduction
On July 11, 2018, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert addressing deficiencies observed in their recent examinations of investment advisers’ best execution practices. For years, advisers have been required to obtain and document best execution on behalf of client account, yet firms continue to struggle with sustainable and effective best execution policy and procedure, according to SEC staff.

The Investment Advisers Act of 1940 (“Advisers Act”) establishes a federal fiduciary standard for investment advisers. As a fiduciary with responsibility to select broker-dealers and execute client trades, the adviser has an obligation to seek “best execution” of client transactions, taking into consideration the circumstances of each particular transaction. An adviser must execute securities transactions for clients in such a manner that the client’s total costs or proceeds in each transaction are the most favorable under the circumstances.

As the Commission makes clear, the determinative factor in an adviser’s best execution analysis is not the lowest possible commission cost but whether the transaction represents the “best qualitative execution” for the account. Of course, to comply with Rule 206(4)-7, advisers must tangibly demonstrate best qualitative execution. And this presents the greatest challenge to advisers, according to the SEC.

An adviser’s assessment of best execution may be impacted by the adviser’s receipt of brokerage and research services (“soft dollar arrangements”).  Advisers are required to develop and document a reasonable allocation of the costs of the products or services received pursuant to the soft dollar safe harbor. Under Section 28(e) of the Securities Exchange Act of 1934 (“Exchange Act”), an adviser may pay more than the lowest commission rate in soft dollar arrangements without breaching its fiduciary obligation, provided that certain specified conditions are met.

 

OCIE Exam Deficiencies – Best Execution
Below are examples of the most common deficiencies associated with advisers’ best execution obligations, identified by OCIE staff in recent examinations.

  • Not performing best execution reviews. Advisers could not demonstrate that they periodically and systematically evaluated the execution performance of broker-dealers used to execute client transactions (and therefore could not prove that client transactions achieved best qualitative execution).
  • Not considering materially relevant factors during best execution reviews. The staff observed that advisers did not consider the full range and quality of a broker-dealer’s services in directing brokerage.  For example, OCIE detected the following:
    • Advisers did not evaluate any qualitative factors relating to broker-dealer selection, including, among other things, the broker-dealer’s execution capability, financial responsibility, and responsiveness to the adviser.
    • Advisers did not solicit and review input from traders and portfolio managers.
  • Not seeking comparisons from other broker-dealers. The staff observed advisers that utilized certain broker-dealers without seeking out or considering the quality and costs of services available from other broker-dealers.  For example, the staff observed:
    • Advisers that utilized a single broker-dealer for all clients without seeking comparisons from competing broker-dealers initially and/or on an ongoing basis to assess their chosen broker-dealer’s execution performance.
    • Advisers that utilized a single broker-dealer based solely on cursory reviews of the broker-dealer’s policies and prices.
    • Advisers that utilized a broker-dealer based solely on that broker-dealer’s brief summary of its services without seeking comparisons from other broker-dealers.
  • Not fully disclosing best execution practices. The staff observed advisers that did not provide full disclosure of best execution practices.  For example, the staff observed advisers that did not disclose that certain types of client accounts may trade the same securities after other client accounts and the potential impact of this practice on execution prices. In addition, the staff observed advisers that, contrary to statements in their brochures, did not review trades to ensure that prices obtained fell within an acceptable range.
  • Not disclosing soft dollar arrangements. The staff observed advisers that did not appear to provide full and fair disclosure in Form ADV of their soft dollar arrangements. OCIE observations included the following:
    • Advisers that did not appear to adequately disclose the use of soft dollar arrangements.
    • Advisers that did not disclose that certain clients may bear more of the cost of soft dollar arrangements than other clients.
    • Advisers that did not appear to provide adequate or accurate disclosure regarding products and services acquired with soft dollars that did not qualify as eligible brokerage and research services under the Section 28(e) safe harbor.
  • Not properly administering mixed use allocations. The staff observed deficiencies related to soft dollar mixed use allocations.  For example, the staff observed advisers that did not appear to make a reasonable allocation of the cost of a mixed-use product or service according to its use or did not produce support, through documentation or otherwise, of the rationale for mixed use allocations as required under Section 28(e).

 

Action Plan
Below we outline various components of a sound trade management policy which may assist advisers in achieving best execution.

Approved Brokers: Many investment advisers maintain a list of approved brokers, populated with firms that have been vetted by the adviser from a due diligence standpoint.  Due diligence inquiry should address several important variables including financial condition, regulatory history, affiliate party relationships and business continuity planning. In certain advisory business models, the trade counterparty is the client’s custodian. However, even in such models, the adviser generally retains the authority to step away from the custodian when it is necessary to obtain best execution. Typical examples of step away (or “step out”) situations include the purchase of a security not available from the custodian, time sensitive transactions, or transactions in highly illiquid securities that require special trading expertise to avoid material market impact on execution prices. Step out procedures, if adopted, must be fully disclosed to clients in Form ADV and referenced in the advisory agreement where appropriate.

Governance:  Best execution oversight is critical to effective trade management. Because the trader is closest to the trade, he/she is often in the best position to determine if best execution has been achieved on a trade-by-trade basis. However, it is precisely because the trader is closest to the trade that an adviser’s governance framework should include professionals not executing trades. Governance considerations relative to the development and implementation of best execution policy should include:

  • Representatives from portfolio management, trading, operations, risk oversight, and compliance
  • The oversight team should include professionals who are independent of the trade management process, i.e., not compensated on achievement of best execution
  • The forensic review of transaction data is critical to the governance framework
    • transaction cost analysis may include measures such as volume weighted average price (“VWAP”), reversion, implementation shortfall, and others
    • implementation shortfall measures the difference between the average price of an execution and the price prevailing at the time the trade is received by a broker or exchange (arrival time)
    • transaction data may be available from executing brokers, as well as independent vendors
  • The SEC has stated that advisers must “periodically and systematically” evaluate the quality of execution services received from the broker-dealers that are used to execute client trades; the governance framework should specify the frequency with which best execution will be evaluated

Quantitative Factors (Cost): The evaluation of best execution should include the actual cost of trading. Cost factors most often include:

  • Commission rates
  • Flat trade fees
  • Transaction prices
  • Exchange fees
  • Service fees
  • Step out fees

Qualitative Factors: Cost is not the only best execution factor to be considered. As noted, the SEC concedes that the objective of best execution is not necessarily to achieve the lowest cost of execution. Qualitative factors should also be evaluated when selecting broker-dealers, including:

  • Execution capability (market access, natural order flow, security types, capital commitment, IPO access, etc.)
  • Quality of research (including soft dollars)
  • Operational capability (service, errors, etc.)
  • Quality of execution (market intelligence, confidentiality, minimizing market impact, access to liquidity, handling of difficult orders, trade error history, etc.)
  • Organizational factors (financial soundness and stability, reputation, sales coverage, etc.)

The creation of a scorecard that is used by governance professionals is a common means of evaluating the qualitative aspect of best execution. It is imperative that advisers implement policies, procedures and controls which reflect these qualitative attributes of the firm’s best execution practices and further, incorporate these qualitative variables in best execution management reports.

Security Type Considerations: The security type certainly impacts best execution protocol. However, no security type is exempt from best execution analysis, whether private equity, bonds, equities, or mutual funds. Cost factors to be considered in each case may include, without limitation:

  • Private equity:
    • Deal execution speed
    • Certainty of financing
    • Operational and strategic expertise, including industry, geography, management team, market potential, product considerations, and growth capabilities
  • Bonds:
    • Bid-ask spreads
    • Odd-lot pricing
    • Competing bids and offers
    • Access to bonds, including new issues
    • Availability of liquidity or volume
  • Equities:
    • Market venue and market conditions
    • Character of the market for the security (e.g., price volatility, relative liquidity, etc.)
    • Size and type of transaction
    • Accessibility of price quotes
    • Number of markets checked
    • Terms and conditions of the order
  • Mutual funds:
    • Expense ratios
    • Investment manager fees
    • Portfolio turnover (higher turnover = higher trading expenses)
    • Share class availability

Soft Dollars: The Risk Alert specifically calls out soft dollars as an area of deficiency cited in examinations. The entire soft dollar landscape is shifting in today’s marketplace for many reasons, including MIFID II. Soft dollars present a conflict of interest because they represent a mechanism for an adviser to use client assets, in the form of commission dollars, to pay for services that would otherwise come out of the adviser’s hard dollar budget. Some brokerage services are not fully protected under the safe harbor, which means the adviser must carefully allocate costs between hard and soft dollars, which requires careful analysis and objectivity. Services paid with soft dollars must be proven to assist in the formulation of investment advice and must meet strict safe harbor guidelines. Not all clients are required to participate in soft dollar arrangements, however advisers must make it clear that those clients whose commissions are used to satisfy soft dollar commitments may likely be footing the bill for those not participating in such arrangements. Disclosures must be clear, detailed, and unambiguous. 

Written Policies: Although there is no best execution rule per say, best execution is specifically named as one of the areas advisers are expected to consider in establishing their written compliance programs under SEC Compliance Rule 206(4)-7. The factors listed above, along with other procedures and controls, should be memorialized in written policies and procedures.

Books and Records: It is vital that investment advisers document their best execution activities. As with most compliance activities, the SEC’s view is if there is no written documentation to evidence the adviser’s pursuit of best execution, the adviser has not met its fiduciary duty to seek best execution.

Disclosures: Do what you say you do! Brokerage disclosures must match the adviser’s actual practices, policies, and procedures. Conflicts of interest inherent in trading practices must be identified, mitigated, and disclosed to the extent they are not removed. Typical conflicts related to best execution include soft dollars, directed brokerage, performance fees, IPO access, step-out trades, block trading, trade rotation and allocation, obtaining client referrals from trade counterparties, cross trading, principal trading, and use of affiliated broker-dealers.

 

Conclusion
The closing statement of the Risk Alert bears consideration: “In sharing the information in this Risk Alert, OCIE encourages advisers to reflect upon their own practices, policies, and procedures in these areas and to promote improvements in adviser compliance programs.”  As we say often, forewarned is forearmed. The SEC has tipped its hand when it comes to its expectations around best execution policies and controls, and therefore investment advisers must adjust their playbook accordingly! 

Source
View the Risk Alert Here: Most Frequent Best Execution Issues Cited in Adviser Exams 

SEC Risk Alert – Frequent Fee and Expense Deficiencies in Adviser Exams

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April 12, 2018:  The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert to highlight recurrent deficiencies observed in their recent examinations of investment advisers’ policies and procedures governing client fee and expense assessments. The deficiencies were identified by OCIE while conducting more than 1,500 investment adviser examinations over the past two years.  This Risk Alert emphasizes the importance of advisers’ provision of clear and thorough disclosures in Form ADV and client investment advisory agreements.  The Risk Alert further underscores prior Commission guidance relating to adviser obligations to develop, implement, and test effective risk-based compliance policies to minimize the risk of misrepresentation in client communications and the risk of misappropriation in the management of client assets.

Most Frequent Compliance Issues – Advisory Fees and Expenses 

The following issues were deemed to be significant and prevalent in nature, although they do not constitute all fee and expense-related findings detected by OCIE.

Read More

SEC Announces Share Class Selection Disclosure Initiative

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February 12, 2018: Investment advisers recommending mutual fund shares to advisory clients may have a disclosure problem. And yes, the U.S. Securities and Exchange Commission (“SEC”) is here to help address the problem. Yesterday the Commission announced its new self-reporting initiative, the Share Class Selection Disclosure Initiative (“SCSD Initiative”), to provide relief to advisers that have engaged in improper mutual fund recommendations on behalf of their clients. This initiative, forgiveness if you will, relates to certain mutual fund share class selections made by advisers relative to the formulation and execution of investment advice. If the offending firm promptly fesses up to the Division of Enforcement and promptly returns any non-compliant fees to harmed clients, the Division will agree not to recommend financial penalties against such advisers for violating federal securities laws. Read More

SEC Issues 2018 Examination Priorities

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February 7, 2018:  We wish our clients and colleagues a very prosperous new year and, this being the kickoff of 2018, we are all once again bestowed with the SEC National Exam Program Examination Priorities for the coming year!  We believe this informal guidance, announced February 7, 2018, can be helpful to Chief Compliance Officers as they recalibrate their compliance programs to adjust for business model evolutions or to realign their own compliance priorities following the 2017 annual review.

The following is a synopsis of the 2018 SEC examination priorities, abridged to present content pertaining primarily to investment advisers. The strategy and principles content has been extracted directly from the release to provide appropriate context to the Commission’s strategic and tactical execution of their mission.   Read More

Labor Department Officially Delays Start of Fiduciary Rule

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December 4, 2017:  Last week, the Department of Labor (“DOL”) officially announced an 18-month extension for the start of key provisions of the Fiduciary Rule. DOL announced that the special Transition Period for the Fiduciary Rule’s Best Interest Contract Exemption (“BICE”) and the Principal Transactions Exemption, and the applicability of certain amendments to Prohibited Transaction Exemption 84-24 (PTEs), will move from January 1, 2018 to July 1, 2019. The extension gives DOL time to consider public comments, review the Fiduciary Rule and related exemptions, and coordinate with the U.S. Securities and Exchange Commission and other securities and insurance regulators. The delay underscores the DOL’s objectives of protecting retirement investors and avoiding unnecessary restrictions imposed upon retirement investors by financial service firms scrambling to fully implement the rule.

The DOL action leaves in place the Fiduciary Rule, effective June 9, 2017, including the revised definitions of fiduciary and investment advice that apply to ERISA plans and IRAs. The DOL’s action continues to recognize various exemptions permitted under the rule. Financial services organizations may rely on the BICE and the Principal Transactions Exemption if they satisfy the Impartial Conduct Standards. The impartial conduct standards, also referred to as the best-interest standard, which took effect on June 9, require fiduciary advisers to adhere to a best-interest standard when making investment recommendations, charge no more than reasonable compensation for their services, and refrain from making misleading statements.

The DOL also announced an extension of the temporary enforcement policy contained in Field Assistance Bulletin 2017-02 to cover the 18-month extension period. Therefore, from June 9, 2017, to July 1, 2019, the DOL will not pursue claims against fiduciaries working diligently and in good faith to comply with the Fiduciary Rule and PTEs, or treat those fiduciaries as being in violation of the Fiduciary Rule and PTEs. However, there is nothing to prevent a client from initiating a private action against a fiduciary for not placing their interests first and foremost as affirmed by the Supreme Court (SEC v. Capital Gaines Bureau 1963).

To our clients who have taken affirmative steps to comply with the Fiduciary Rule and demonstrate compliance with the Impartial Conduct Standards, we recommend that you continue to follow your enhanced policies and procedures. To those firms who have not yet implemented policies and procedures, we recommend that you do so.

Action steps to consider, if not already implemented:

  • Identify and segment all retirement investors as ERISA Plans, IRAs, etc. to facilitate tracking, disclosures, and management reporting.
  • Update compliance policies and procedures to document Fiduciary Rule compliance.
  • Update investment advisory agreements and Form ADV disclosures to clarify your firm’s fiduciary status and address inherent conflicts of interest.
  • IRA rollovers should be treated as a fiduciary activity unless it can be clearly and conclusively established that the firm’s role is purely informational, and does not involve the rendering of advice.  Client disclosures and written internal rollover analysis requirements should be in place.
  • Review all marketing materials and disclosures with a view to identifying and eliminating any statements that could be viewed as misleading or inadvertently deemed to constitute a fiduciary recommendation.
  • Evaluate all revenue streams and compensation programs to comport to the Fiduciary Rule exemption under which your firm has chosen to operate (i.e., level pay).
  • Evaluate the use of proprietary products and investments that generate third-party payments in retirement accounts to make sure use of such products is consistent with the best interest standard.
  • Consider benchmarking fees to defend the reasonableness of fees as being in the best interest of retirement investors.
  • Identify the party or parties in your firm responsible for overseeing compliance with the Impartial Conduct Standards.
  • Review insurance policies to ensure that coverage is appropriate under the new Fiduciary Rule.

Please call on us for assistance in implementing the Fiduciary Rule.

2017 SEC Enforcement Division Playbook

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November 27, 2017:  The U.S. Securities and Exchange Commission (“SEC”) was established by an Act of Congress to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Compliance with the Investment Advisers Act, the Investment Company Act, and other federal securities statutes is highly dependent upon the adviser’s capacity to fully appreciate where the SEC is headed when they contemplate a deficiency letter, enforcement action, or referral to the Department of Justice.  For investment advisers, all aspects of the SEC mission statement have a direct correlation to the adviser’s business model, i.e., the non-compliant registered investment adviser presents an ongoing threat to undermine the Commission’s execution of its mission statement and therefore attracts significant resources and scrutiny from the regulator.

Fiscal year 2017 was by all accounts a successful year for the SEC’s Division of Enforcement. The Commission brought 754 actions and obtained judgments and orders totaling more than $3.7 billion in disgorgement and penalties. Significantly, it also returned a record $1.07 billion to harmed investors, suspended trading in the securities of 309 companies, and barred or suspended more than 625 individuals.

The Commission recently announced that in its fiscal year 2018, it will deliver a 20 per cent increase in the number of examinations of US investment advisers year-over-year.[1] In June of 2017, the SEC announced the reassignment of 100 staff to adviser exams from the broker-dealer regime. In testimony before Congress, Chairman Jay Clayton noted that “for at least the next several years we will need to do more each year to increase the agency’s examination coverage of investment advisers in light of continuing changes in the markets…”[2]

Beyond the OCIE Deficiency Letter, there are three manifestations of an SEC enforcement action to be imposed upon a non-compliant investment adviser if in fact the adviser’s compliance program is required to suffer the ignominy of a referral to the Enforcement Division.  In roughly equal measure they are, penalties and fines, disgorgement of ill-gotten gains, and suspensions or bars that prevent wrongdoers from working in the securities industry.  The latter has become a more widely utilized enforcement mechanism as the SEC seeks to reaffirm the personal accountability of professionals for acts of commission and omission which undermine the SEC’s mission.

The Division of Enforcement’s recently released 2017 Annual Report reveals significant insight into the current orientation of the Commission and its unwavering focus upon robust execution of its mission statement.[3]

The Commission is steadfast in its execution of all three mission axes however the protection of investors remains a significant focus year after year regardless of political or budgetary considerations. This reality drives SEC resource allocation in the following investor protection subsets: cyber-related misconduct, non-compliant activities of investment advisers, financial reporting, insider trading, and market abuse.   To closely align allocation of resources with two key SEC priorities—protecting retail investors and combatting cyber-related threats—at the end of fiscal year 2017, the Division announced the creation of a Cyber Unit and a Retail Strategy Task Force.

The Cyber Unit combines the Enforcement Division’s substantial cyber-related expertise and its proficiency in digital ledger technology.  This component of the Enforcement Division will focus upon the following risk inflection points:

  • Market manipulation schemes involving false information spread through electronic and social media;
  • Hacking to obtain material nonpublic information and trading on that information;
  • Violations involving distributed ledger technology and initial coin offerings (ICOs);
  • Misconduct perpetrated using the dark web;
  • Intrusions into retail brokerage accounts; and
  • Cyber-related threats to trading platforms and other critical market infrastructure.

 

The Retail Strategy Task Force is a component of the Enforcement Division which focuses upon the protection of investors and relies heavily on the ongoing development and utilization of proprietary technology and data analytics to identify violations of federal securities statutes.  The primary focus of the Retail Strategy Task Force will center on the following risk areas:

  • Microcap markets;
  • Offering frauds (where victims typically are retail investors); and
  • The intersection of investment professionals and retail investors.

 

With respect to the latter area of risk, the Enforcement Division will scrutinize misconduct wherein advisers:

  • Steer clients to higher-cost mutual fund share classes;
  • Abuse wrap fee account protocol (churning, excessive trading, etc.); and
  • Provide investor recommendations to buy and hold highly volatile products like inverse exchange-traded funds and/or provide unsuitable advice to purchase structured products.

Clearly the creation and funding of these Enforcement resources place the non-compliant registered investment adviser in greater reputational and regulatory jeopardy. A long forgotten Chinese philosopher once remarked “a picture is worth a thousand words.”  In this same vernacular, one should refer to data provided by the Enforcement Division wherein an interesting “picture” emerges relating to the current and prospective orientation of the Enforcement Division.

Even in the midst of a transition in leadership, 2017 was an impactful year for the Enforcement Division. The Commission brought a diverse mix of 754 enforcement actions, of which:

  • 446 were “standalone” (wherein the Commission either sued in civil action or referred to the Department of Justice in criminal action, individual defendants rather than subsets of defendants) actions brought in federal court or as administrative proceedings;
  • 196 were “follow-on” proceedings seeking bars based on the outcome of Commission actions or actions by criminal authorities or other regulators; and
  • 112 were proceedings to deregister public companies—typically microcap—that were delinquent in their Commission filings.

 

Consistent with the Division’s focus upon personal accountability, over 73% of the standalone actions entailed prosecution of non-compliant individuals while approximately 20% of these actions involved investment advisers and their personnel. Total monies ordered paid by defendants in fiscal year 2017 was $3.789 billion, comprised of $832 million in penalties and $2.957 billion in disgorgement.

A deeper dive into the numbers reveals a well-known fact … a small number of enforcement actions (generally against larger firms) constitute most of the penalties and disgorgements. Indeed, 5 percent of cases that involve the largest penalties and disgorgement account for most of the financial remedies the Commission obtained in its last fiscal year.  However, the remaining 95 percent of cases not only constitute the bulk of the Enforcement Division’s overall activity and resources, but also address the broadest array of conduct. There should be no doubt that the Enforcement Division is intent on protecting all investors regardless of whether they are serviced by the very large investment adviser or the small adviser.

As noted, monetary sanctions and disgorgements are two legs of the enforcement protocol. A third and very effective means of behavioral modification utilized by the Enforcement Division entails removing bad actors from the securities industry altogether, whether as a suspension or a permanent bar. One of the most important things that the Commission can do proactively to protect investors and the market is to remove bad actors from positions where they can engage in future wrongdoing. Bars and suspensions allow the SEC to prevent wrongdoers from serving as officers or directors of public companies, dealing in penny stocks, associating with registered entities such as broker-dealers and investment advisers, or appearing or practicing before the Commission as accountants or attorneys. Enforcement actions resulted in over 625 bars and suspensions of wrongdoers in fiscal year 2017 and over 650 bars and suspensions in fiscal year 2016 pursuant to the SEC’s intent to focus upon personal accountability.

Insight into the Commission’s enforcement activity and underlying rationale provides a very valuable perspective to the adviser registrant intent on attaining and maintaining a culture of compliance. To this end, enforcement actions are closely watched by registrants and their agents. This scrutiny leads to improved compliance risk management and training as non-compliant behavior is modified.  In this respect the actions of the Enforcement Division have a multiplier effect insofar as enforcement actions have a meaningful impact on market participants who are not involved in the particular misconduct that has been charged.

Of course, it is understood that registered advisers design their compliance risk management programs to avoid contact with the Division of Enforcement.  Perhaps less understood that bears reinforcement with advisory staff is that personal accountability has never been more important.


[1] http://www.investmentnews.com/article/20170627/FREE/170629933/despite-leaner-budgets-secs-clayton-anticipates-a-5-increase-in

[2] Testimony on “Oversight of the U.S. Securities and Exchange Commission” by Chairman Jay Clayton, Washington D.C., Sept. 26, 2017

[3] https://www.sec.gov/files/enforcement-annual-report-2017.pdf

SEC Issues Additional Guidance – Form ADV Updates

By | New in Compliance, SEC

August 17, 2017:  Earlier this week, the Division of Investment Management of the U.S. Securities and Exchange Commission (“SEC”) issued IM Information Update 2017-06, directed to investment advisers filing Form ADV updates.  As widely reported, in August 2016, the Commission adopted amendments to Form ADV with a compliance date of October 1, 2017.[1] As of that date, any adviser filing an initial Form ADV or an amendment to an existing Form ADV will be required to provide responses to the form revisions adopted in the rulemaking. Read More