Category: SEC News

Bold and Unrelenting SEC Enforcement

We are in a time of transition at the Securities and Exchange Commission. There are two vacancies on the Commission and Chair Mary Jo White has announced her departure. Although there are changes coming to the highest level of the SEC, the vast majority of the SEC personnel are staying in place and continuing their efforts to protect investors.

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Chair White gave a speech to the NYU Program on Corporate Compliance and Enforcement and the NYU Pollack Center for Law and Business about the SEC’s enforcement program.

During Chair White’s confirmation hearings, she pledged to would pursue a “bold and unrelenting” enforcement agenda as SEC Chair. That was combined with a change in the way enforcement approached cases.

Investigate to Litigate – The SEC staff is coached to conduct all investigations with litigation in mind. During investigations, staff will focus on acquiring admissible and persuasive evidence

Use of Data Analytics to Uncover and Investigate Misconduct – These efforts have resulted in at least nine insider trading cases originating solely from leads generated by these types of tools, many others in the pipeline, and dozens of other cases being expanded using these tools to identify additional unlawful trading

Using Whistleblowers to Detect Misconduct – The SEC recently surpassed the $100 million mark for awards to whistleblowers, and tips in fiscal year 2016 surpassed 4,200, rising over 40 percent from 2012, the first fiscal year the program was in place.

Focusing on Individuals – Holding individuals liable for wrongdoing is a core pillar of any strong enforcement program.

The SEC’s Admissions Policy – In a first for a civil financial regulator, we announced in June 2013 that the SEC would begin to require admissions as a condition for settlement in certain types of cases, including cases with harm to large numbers of investors or significant risk of harm to the market, where the settling party engaged in egregious conduct or obstructed Commission investigations, or where admissions would significantly enhance the deterrent message of the action.

Impact of SEC Enforcement Activity – We have also, however, increasingly brought cases – including those involving negligent actions – that harm investors in other important ways that can be remedied through changes in industry practices in response to our actions, thus benefiting huge segments of investors beyond those harmed in a specific case.

In this last area, Chair White highlights the effect of enforcement on private equity.

“Over the past three years, we have brought 11 actions against private equity advisers for undisclosed fees and expenses, impermissible shifting and misallocation of expenses, and failure to adequately disclose conflicts of interests to clients. Our strong sense from exams and industry discussions is that, through the Commission’s focus on these problematic practices, we have helped to transform the level of transparency of fees, expenses, and conflicts of interest, and have prompted very meaningful change for the benefit of investors.”

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When Does A Stock Picking Contest Turn Into a Derivative

Forcerank’s premise was simple: “fantasy sports for stocks”.

Forcerank runs mobile phone games where players predict the order in which stocks would perform relative to each other.  In its original form, if a player did well he or she won points and could some receive a cash prize. Forcerank kept 10 percent of the entry fees.

The gaming is a ruse to collect data. Forcerank iss looking to obtain data about market expectations that it hopes to sell to hedge funds and other investors.

forcerank

It seems clear to me that Forcerank was concerned about the gambling aspect of the app. There was a provision in the rules the stated the Forcerank contest was a “skill based” contest. If it were not skill-based (i.e luck) then it would be gambling. You pay an entry fee and if you win you get a prize. If winning is based on luck it’s gambling.

The Securities and Exchange Commission looked at the Forcerank contest in a different light.

Dodd-Frank gave the SEC new powers to regulate security-based swaps.

The Commodity Exchange Act defines the term “swap”:

“[T]he term ‘swap’ [includes] any agreement, contract, or transaction—… (ii) that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence[.]”

That’s a very broad definition. It was a definition that the SEC applied to the Forcerank contests.

[E]ach Forcerank entry was a swap because each participant paid to enter into an agreement with Forcerank LLC that provided for the payment of points and, in certain cases, cash. Those payments were dependent upon the occurrence, or the extent of the occurrence, of an event or contingency (i.e., the player’s predictions about the price performance of individual securities being compared to actual performance and the player’s aggregate points being compared to other players). Such event or contingency was “associated with a potential financial, economic or commercial consequence” because it was calculated by measuring the change in the market price of an individual security over a period of time and comparing that change to an identical metric based on the market price of other individual securities.

I find this an interesting roadblock to stock-picking contests.

I looked at the Forcerank website and downloaded the app. There is no longer an entry fee and there are no cash prizes. That removes it from the definition of “derivative”. It also removes the incentive to enter the contest and the revenue stream from Forcerank.

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See the Changes to Form ADV

With all the regulatory changes to Form ADV coming out, I found it tough to figure out what the changes look like on the form. The Securities and Exchange Commission published a helpful redline that highlights the changes.

The SEC is not willing to stand behind the redline, noting:

This document illustrates most of the revisions to Form ADV related to adopted rule release IA-4509. This document should not be considered a complete and comprehensive list of changes to Form ADV.

I think many will find the “separately managed account” portion to be confusing. The first being the use of this term which sounds much like the term, separate account, used in the insurance industry to invest. The borrowing and derivatives reporting will be time-intensive.

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Separately Managed Accounts

The biggest change to the Form ADV is reporting on separately managed accounts. The Securities and Exchange Commission is looking for data and insight into advisers’ operations. I think the benefit to consumers is a side benefit.

Cash in the grass.

I have to admit that I was confused as I was browsing through the new changes to Form ADV. I mistook “separately managed accounts” for “separate accounts.” That left me particularly confused when the section started with the scope of the changes:

we consider advisory accounts other than those that are pooled investment vehicles (i.e., registered investment companies, business development companies and pooled investment vehicles that are not registered (including, but not limited to, private funds)) to be separately managed accounts.

Later on in the release, the SEC specifically chooses not to define “separately managed accounts.” That only exacerbated my initial confusion. Many advisers and fund managers are familiar with separate accounts, a species of investing vehicle used by insurance companies

Then the light came on and realized that the SEC had created a completely new term that compliance professionals for registered investment advisers will need to learn and understand. There are “separate accounts” and “separately managed accounts.”  To add to the confusion, a separate account could be a separately managed account. But maybe that was just me.

With Dodd-Frank giving the SEC more oversight over private funds, it realized that it was collected vast amounts of information about private funds, but much less about the bread and butter separately managed accounts. But rather than collect that information in the private manner for Form PF, the SEC is mandating additional disclosure in the public Form ADV filing.

Registered investment advisers will have to report the approximate percentage of their separately managed account assets invested in twelve asset categories:

  1. exchange-traded equity securities;
  2. non-exchange traded equity securities;
  3. U.S. government bonds;
  4. U.S. state and local bonds;
  5. sovereign bonds;
  6. corporate bonds – investment grade;
  7. corporate bonds – non-investment grade;
  8. derivatives;
  9. securities issued by registered investment companies and business development companies;
  10. securities issued by other pooled investment vehicles;
  11. cash and cash equivalents; and
  12. other

Don’t look for definitions of these terms in Form ADV. The SEC is leaving it up to advisers to determine how to categorize assets, so long as the methodology is consistently applied. If an adviser has more than $10 billion in RAUM, the information will have to be reported twice a year, instead of just an annual filing.

If an adviser has more than $500 million in RAUM, the adviser will have to disclose the use of borrowing attributable to those assets. If the adviser has more than $10 billion in RAUM, the adviser will also have to report on the use of derivatives in those accounts.

As with private funds, advisers will need to report information on the use of custodians. The new Item 5.K.(3) requires investment advisers to identify any custodian that accounts for at least 10 percent of total RAUM attributable to its separately management accounts, the custodian’s office location and the amount of RAUM held at the custodian.

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SEC Brings Another Private Equity Fund Fee Case

Apollo has been variously recognized as a god of sun, truth, healing, and poetry, and more in classical Greek and Roman mythology. It’s namesake private equity firm has settled charges with the Securities and Exchange Commission that it was less than truthful in disclosing fees charged to investors.

Giuseppe_Collignon_-_Prometheus_Steals_Fire_from_Apollo's_Sun_Chariot,_1814

The main thrust of the Apollo case was over monitoring fees. Apollo, like many private equity firms, charged a monitoring fee to its portfolio companies. The SEC has previously announced its distaste for these fees, especially when the fees relate to periods after the sale of the portfolio company.

Apollo disclosed in its fund documents that it charge monitoring fees. The SEC felt that Apollo did not adequately disclose that sometimes these fees would be accelerated upon the sale of a company and therefore earn a fee for period where there was no company to monitor.

I believe this practice has largely stopped in the private equity world or the disclosure is now more robust regarding this standard industry practice.

Regardless, it was a big chunk of change. The order lists $37 million of disgorgement.

In addition to its distaste of monitoring fees, the SEC did not like a loan from the funds to the management company. It’s not clear from the order what was going on with the loan, but it looked like a vehicle to defer taxes on carried interest. The fatal flaw for the SEC was that the accrued interest on the loan was allocated to the fund’s GP which was not fully disclosed in the financial statements.

Lastly, one of Apollo’s senior partners charged personal items to the funds in violation of the Apollo’s policies. This conduct was repeated. Apollo ended up firing the partner and making him (or her) repay the expenses. Apollo self-reported this to the SEC.

But still the SEC decided to include that expense infraction in this order.

Private fund compliance professionals have been focusing on fees and expenses. To me the monitoring fee is a leftover from a few years ago when the SEC announced its distaste for the practice. It’s not clear to me what impact the loan had on the fund investors.

Clearly, the fund investors were made whole by the malfeasance of the senior partner. Apollo did everything right in that context, including self-reporting. I’m not sure why the latter item had to be part of a big, public enforcement action.

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SEC’s In-House Courts Are Upheld

There have been several challenges to the constitutionality of the in-house judges at the Securities and Exchange Commission. The problem is that the judges are appointed by an internal panel instead of by the President or the SEC Commissioners. That will not make a difference for Raymond Lucia and his “Buckets of Money.”

SEC Seal 2

Radio personality Raymond J. Lucia, Sr. got in trouble with the SEC by claiming that his “Buckets of Money” strategy had been successfully backtested when in fact it had not been. Lucia was a registered investment advisor, but the SEC barred him for his transgressions. He appealed.

In addition to appealing the substance of the charges against him, he argued that the SEC in-house court was unconstitutional. The appeal looked at the Appointments Clause of the Constitution. It’s an important part of the constitution to make sure that those who wield power are subject to “political force and the will of the people.” The President appoints “Officers” who are those who exercise “significant authority pursuant to the laws of the United States.”

The court went out to point out a three prong test to determine if an official is an “Officer” under the Appointments Clause:

  1. significance of the matters resolved by the government official
  2. discretion the official exercises in reaching the decision
  3. the finality of the decision

So far it sounds good for Mr. Lucia and the other parties arguing this point in their disciplinary matters.

But then there is the procedural matter of what happens after an SEC in-house judge issued his or her order. Under the SEC rules, there is not final decision until the Commission determines not to review the order. That initial order from the SEC judge only becomes final when the Commission issues the finality order. “The Commission’s final action is either in the form of a new decision after de novo review or, by declining to grant or order review, its embrace of the ALJ’s initial decision as its own.”

That leaves the full decision-making powers in the hands of the SEC commissioners who are appointed by the President in accordance with the Appointments Clause.

That seems to settle the argument that the SEC in-house administrative proceedings are unconstitutional.

Of course, Mr. Lucia could appeal this decision further. The Supreme Court may want to take a different view of who is an “officer” under the Appointments Clause.

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Cycling and the Securities and Exchange Commission

The big news in cycling over the weekend was the end of the Tour de France. Other news is a personnel change at the Securities and Exchange Commission because of cycling.

sky and froome

Chris Froome and his Team Sky dominated the General Classification of the Tour de France. He finished more that four minutes ahead of his nearest rival. He took the yellow jersey and the initial time advantage in an unusual manner. He attacked at the top of a big climb while his rivals paused. He was gone before they realized what happened. In a later stage he gained more time in an unusual attack paired with Peter Sagan, the holder of the sprinters’ green jersey, and two teammates when crosswinds fractured the peloton. In the usual manner Froome gained time on his rivals in the time trials and held off their attacks in the mountains using his incredibly strong team.

For the SEC, the Chief Accountant, James V. Schnurr, was in a serious bicycle crash. Serious enough that the SEC appointed Wesley R. Bricker as the Interim Chief Accountant.

I was disappointed that the SEC chose to use the word “accident” in the press release. Accident applies that there was no fault and perhaps was not preventable. Unfortunately, I was not able to find a news story about the crash.

As someone who regularly bikes to work, I can tell you that there are few accidents. Of course there are cyclists breaking the law. (I still don’t understand why so many run red lights.) But a bike is going to little damage if it crashes into a car. A car will do tremendous damage if it crashes into a cyclist.

I see many, many distracted drivers while on my bike commute: watching videos, texting, emailing, facebooking, catching pokemons. They seem oblivious that they are directing 3000 pounds of metal with potentially deadly force.

It’s not an “accident” when the driver has chosen to be distracted. “I didn’t see him,” is more often because the driver chose to pay attention to some other distraction instead of the other cars, cyclists and pedestrians in and around the roadway.

I hope you are not one of those distracted drivers.

On a happy note, this is one of the great watercolors by Greig Leach for sale at The Art of Cycling. This one captures the battle of sprinters at the end of stage 3. But you’ll have to pick one of the other watercolors because this one is in my living room.

If you enjoy Compliance Building, please support my Pan-Mass Challenge ride to fight cancer on August 5-7. 100% of your donation goes to the fight against cancer. You can read more and donate here: http://profile.pmc.org/DC0176

Photo Finish in Angers small

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Share Class Initiative

If your firm receives revenue from the sale of funds, be sure you have procedures in place to avoid placing clients in a more expensive share class when a cheaper one is available. The SEC announced a new Share Class Initiative for 2016.

There are two main areas where an adviser will have conflict in this area.

  1. A firm where the adviser is also a broker-dealer or affiliated with a broker-dealer that receives fees from sales of certain share classes
  2. Situations where the adviser recommends that clients purchase more expensive share classes of funds for which an affiliate of the adviser receives more fees.

Those are obvious situations where the adviser has a conflict.

The alert highlights the March action against Everhart Financial Group. The firm was collecting 12b-1 fees from mutual funds that it directed its clients to buy. The firm failed to disclose that it was collecting those fees. The firm later revised its advisory agreements and stated:

EFG’s representatives “may receive 12b-1 fees from certain mutual funds… . Receiving 12(b)-1 fees represents an incentive for a registered representative to recommend funds with 12(b)-1 fees or with higher 12(b)-1 fees than funds with no fees or lower fees.”

Disclosure did not seem to be enough. EFG did not present its clients with information on funds that did not pay 12b-1 fees to the firm. It did not seem to have a good basis for when it would chose a fund with a fee and when it would not. There was no procedure for discussing cheaper class funds with clients. This was a best execution failure.

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Chaos in Commissioner Confirmation

I thought the picks for Securities and Exchange Commissioner would fly through the confirmation process. I was clearly wrong and Congress is even more dysfunctional than I thought.

fairfax and peirce

The SEC is now down to just three members after two left the agency late last year. President Obama nominated Lisa Fairfax, a Democrat, and Hester Peirce, a Republican, to fill the vacancies. Each side of the political divide would likely find one acceptable and accept the other as part of a package.

The discussion about the nominees was held in executive session so we don’t know exactly what was said.

Many groups have urged the SEC to adopt a rule requiring public companies to disclose political donations to nonprofit groups that can spend unlimited amounts of money on political advocacy and advertising. Direct corporate contributions to candidates and party committees already are disclosed. Personally, I don’t see how that affects the SEC missions to protect consumers and have healthy capital markets. The argument is that shareholders should know which political candidates or causes are receiving their money.

Four Senators are holding up the nomination based on this issue. Charles Schumer of New York and Robert Menendez of New Jersey, said they would oppose the SEC picks. They are joined by Elizabeth Warren of Massachusetts and Jeff Merkley of Oregon.

The four Senators feel that the nominees don’t have sufficient belief in further regulating campaign spending by public companies. It will be curious how this should be handled since the 2016 spending bill explicitly denied the SEC the funds to issue or implement this rule.

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The SEC’s New Office of Risk and Strategy

Whenever the Securities and Exchange Commission reorganizes you have to wonder what the impact will be on those subject to regulation by the SEC. Earlier, the SEC announced a new Office of Risk and Strategy within the Office of Compliance Inspections and Examination.

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“The Office of Risk and Strategy will lead our exam program’s risk-based, data-driven, and transparent approach to protecting investors,” said OCIE Director Marc Wyatt. According to the SEC’s press release “[t]he new office will consolidate and streamline OCIE’s risk assessment, market surveillance, and quantitative analysis teams and provide operational risk management and organizational strategy for OCIE.”

I think it’s a good thing for OCIE to increase its use of data in looking at risky firms. The amount of data coming into the SEC has increased dramatically with addition of private fund managers into SEC registration, the Form PF filings and increased trade review.

The news has been sparse as to whether the new office is a new initiative or merely a centralization of existing initiatives. OCIE has been saying for years that its exam process is risk driven. Leading up to an exam, OCIE has looked at many other firms to determine that those present fewer risks.

Hopefully, the new office will allow the SEC to better focus on firms with greater risk.

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