Is the Names Rule effective in preventing misleading or deceptive fund names? The Securities and Exchange Commission (SEC) is seeking public input from funds, investors and other market participants on Rule 35d-1 under the Investment Company Act of 1940 (Names Rule). The SEC identified several fund developments and challenges to applying the Names Rule since it was adopted in 2001 and issued a request for public comment.
To nobody’s great surprise, on June 5, the SEC approved the “Reg BI Package,” which includes a series of new standards governing the fiduciary responsibilities of broker-dealers and investment advisers. The approved items consisted of the Regulation Best Interest – Standard of Conduct for Broker-Dealers; Form CRS Relationship Summary; Standard of Conduct for Investment Advisers; and Interpretation of “Solely Incidental,” all of which seem likely to have considerable impact on the industry going forward.
Over the last year, the SEC has continued to intensify its focus on disclosures from investment advisers on Forms ADV regarding several issues, including—but not limited to—revenue sharing arrangements. Last week, the D.C. Court of Appeals handed down a decision that will likely have significant ramifications for investment advisers and the SEC’s Division of Enforcement (“Enforcement”). In Robare Group, Ltd., v. SEC, the D.C. Circuit upheld the SEC Commission’s decision that the use of the word “may” in a disclosure regarding an investment adviser’s conflicts of interest pertaining to revenue sharing violated the negligence-based fraud provision of Section 206(2) of the Investment Advisers Act of 1940 (“Advisers Act”).
On appeal, The Robare Group, Ltd., a Texas-based investment adviser, argued that the evidence presented by Enforcement in an administrative proceeding did not support the Commission’s ruling, upon review, that their disclosures regarding conflicts of interest relating to a revenue sharing agreement were inadequate. Sections 206(2) and 207 of the Advisers Act were at issue on appeal.
Robare used Fidelity Investments for execution, custody, and clearing services for its advisory clients. Robare entered into a revenue sharing arrangement with Fidelity Investments in 2004. Through that arrangement, Fidelity paid Robare when its clients invested in certain mutual funds offered on Fidelity’s platform. Robare received nearly $400,000 from Fidelity from 2005 to 2013 as a result of the arrangement.
Robare had modified its Form ADV disclosures in December 2011, after Fidelity advised Robare that it would cease making payments if the arrangements were not disclosed. Robare’s disclosures then stated that certain investment advisers “may receive selling compensation” due to “the facilitation of certain securities transactions on Client’s behalf” through certain broker-dealers, or “may also receive compensation resulting from the sale of insurance products to clients.” Robare further revised its disclosures to state, “Additionally, we may receive additional compensation in the form of custodial support services from Fidelity based on revenue from the sale of funds through Fidelity. Fidelity has agreed to pay us a fee on specified assets, namely no transaction fee mutual fund assets in custody with Fidelity. This additional compensation does not represent additional fees from your accounts to us.”
In 2014, Enforcement filed charges against Robare and its principals alleging that Robare had failed for years to disclose to clients and the SEC that it received shared revenue from Fidelity and the conflicts of interest that consequently arise therefrom. Enforcement alleged that Robare’s conduct violated Sections 206(2) and 207 of the Advisers Act. In 2015, an administrative law judge dismissed the charges. Enforcement appealed, and the Commission saw the situation differently. In the Commission’s opinion, it found that Robare negligently failed to adequately disclose said conflicts and willfully failed to provide enough information in its Form ADV filings.
In last week’s ruling, the D.C. Circuit agreed with the Commission and Enforcement that Robare’s disclosures “did not disclose that [Robare] had entered into an arrangement under which it received payments from Fidelity for maintaining client investments in certain funds Fidelity offered.” It further found that the Form ADV “in no way alerted its clients to the potential conflicts of interest presented by the undisclosed arrangement.” The D.C. Circuit agreed with Enforcement that Robare and its principals should have known that their disclosures were inadequate and, therefore, acted negligently in violation of Section 206(2).
The Section 207 charge as alleged, however, requires willful conduct. The SEC has steadfastly maintained over the years that “willful” under the federal securities laws simply means “intentionally committing the act which constitutes the violation” and not that “the actor [must] also be aware he is violating one of the Rules or Acts.” See Wonsover v. SEC, 205 F.3d, 408, 414 (D.C. Cir. 2000). The DC Circuit rejected Enforcement’s arguments that the challenged Section 207 negligent conduct constituted “willful” conduct and explained that “[t]he statutory text signals that the Commission had to find, based on substantial evidence, that at least one of [Robare’s] principals subjectively intended to omit material information from [Robare’s] Form ADV” to prove a violation of Section 207. It was established that Robare’s conduct was negligent, not willful, and the two are mutually exclusive. As a result, Robare was not found to be in violation of Section 207.
To be sure, the Robare decision bolsters the SEC’s longstanding position that disclosures using “may” are not sufficient when the adviser “is” receiving fees or “is” engaging in other practices that create a conflict of interest.
On the other hand, the Robare opinion and ruling with respect to “willfulness” is likely to significantly impact the SEC’s charging decisions with respect to Section 207 and certain other provisions of the federal securities laws, and the SEC’s ability to obtain certain remedies for which willfulness is required.
The SEC’s OCIE recently issued a Risk Alert focusing on compliance issues related to Regulation S-P, the primary SEC rule governing compliance practices for privacy notices and safeguard policies for investment advisers and broker-dealers. The Risk Alert summarizes the OCIE’s findings from two-year’s worth of issues identified in deficiency letters to assist investment advisers and broker-dealers in adopting and implementing effective policies and procedures for safeguarding customer records and information pursuant to Regulation S-P.
On March 11, 2019, the SEC announced and released settlements against 79 self-reporting registered investment advisers (RIAs), touting $125 million being returned to investors. The actions stem from the SEC’s Share Class Selection Disclosure Initiative (SCSD Initiative). The SCSD Initiative incentivized RIAs to self-report violations resulting from undisclosed conflicts of interest, to promptly compensate investors, and to review and correct fee disclosures. Specifically regarding Rule 12b-1 fees, the SEC’s orders found that the RIAs failed to adequately disclose conflicts of interest related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available.
SEC Chairman Jay Clayton commented: “I am pleased that so many investment advisers chose to participate in this initiative and, more importantly, that their clients will be reimbursed. This initiative will have immediate and lasting benefits for Main Street investors, including through improved disclosure. Also, I am once again proud of our Division of Enforcement for their vigorous and effective pursuit of matters that substantially benefit our long-term, retail investors.”
While the SEC and its Division of Enforcement may be pleased, the various industry reactions during the course of the SCSD Initiative included frustration–and at times reasonably so. Tempering that frustration, is that the SEC’s focus on RIA conflicts of interest and disclosures continues. First, there is an expectation that the SEC will announce more settlements in the future for additional SCSD Initiative participants and that this may involve a grouping of a “second wave” of settlements. Second, Enforcement’s Asset Management Unit has already opened investigations into RIAs who did not self-report. Lastly, these investigations included requests for documents and information regarding revenue sharing practices and disclosures.
In conclusion, it is expected that the SEC’s aggressive enforcement efforts regarding RIA conflicts of interest and disclosures to Main Street investors will continue and has already expanded to include revenue sharing.
Pursuant to their fiduciary duties, investment advisers have certain obligations to seek out “best execution” for client transactions. The SEC’s Office of Compliance Inspections and Examinations (OCIE) recently issued a Risk Alert identifying deficiencies found during examinations of investment advisers’ compliance with their best execution obligations.
In this alert, partner Jim Lundy and associate Kellilyn Greco outline OCIE’s findings, including background on best execution, notable deficiencies, and recommended best practices.
On February 7, 2017, the Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert discussing the five most frequent compliance topics identified in OCIE examinations of investment advisors. The Alert was compiled based on deficiency letters from over 1,000 investment adviser examinations completed during the past two years. The top five topics are: (1) the Compliance Rule; (2) Regulatory Filings; (3) the Custody Rule; (4) the Code of Ethics Rule; and (5) the Books and Records Rule.
The Compliance Rule
The Compliance Rule requires: (1) written and policies and procedures reasonably designed to prevent violations of the Advisers Act; (2) annual review of the policies and their implementation; and (3) a chief compliance officer who monitors the policies and procedures. Examples of common Compliance Rule problems included:
- Advisers did not follow their compliance policies and procedures;
- Annual reviews were not performed or did not address the adequacy of the adviser’s policies and procedures;
- Compliance manuals were not reasonably tailored to the adviser’s business practices; and
- Compliance manuals were not current.
OCIE frequently cited advisers for failing to make timely and complete regulatory filings, such as Form ADV (as required by Rule 204-1 under the Advisers Act), Form PF (as required by Rule 204(b)-1 under the Advisers Act), and Form D (as required by Rule 503 under Regulation D of the ’33 Act) on behalf of an adviser’s private fund clients. Timely, accurate, and appropriately amended regulatory filings, especially for these three forms, should be a priority for all advisers.
The Custody Rule
The Custody Rule, which applies to advisers who have custody of client cash or securities, is designed to safeguard client assets from unlawful activity or financial problems of the adviser. OCIE identified the following common deficiencies or weaknesses with respect to the Custody Rule:
- Advisers did not recognize they had “custody” due to: (1) having online access to client accounts, or (2) having other authority over client accounts (such as having power of attorney or serving as a trustee of client trusts); and
- Surprise examinations by independent accountants were not actually a surprise, and advisers failed to fully disclose custody lists during surprise examinations.
The Code of Ethics Rule
The Code of Ethics Rule requires that advisers adopt and maintain a code of ethics that meets certain minimum requirements, and which is described in Form ADV and made available to clients or prospective clients. Deficiencies or weaknesses regarding the Code of Ethics Rule were often found because:
- Advisers failed to identify all of their access persons;
- Codes did not specify review of the holdings and transactions reports, and did not identify specific submission timeframes;
- Submission of transactions and holdings were untimely; and
- Advisers failed to describe their code of ethics in Form ADV.
The Books and Records Rule
The maintenance of books and records as dictated by SEC requirements is another frequent problem area according to OCIE. Some advisers had contradictory information within separate sets of records, while other advisers either maintained inaccurate records or failed to update their records in a timely fashion. Worse still, other advisers simply failed to maintain all of the records that the Books and Records Rule requires them to keep.
The Securities and Exchange Commission (SEC or Commission) Office of Compliance Inspections and Examination (OCIE) issued a Risk Alert on October 24, 2016, titled “Examining Whistleblower Rule Compliance.” This recent Risk Alert continues the SEC’s aggressive efforts to compel Rule 21F-17 compliance and puts the investment management and broker-dealer industries on formal notice that OCIE intends to scrutinize registrants’ compliance with the whistleblower provisions of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank). By way of background, Dodd–Frank established a whistleblower protection program to encourage individuals to report possible violations of securities laws. Importantly, in addition to providing whistleblowers with financial incentives, Rule 21F-17 provides that no person may take action to impede a whistleblower from communicating directly with the SEC about potential securities law violations, including by enforcing or threatening to enforce a severance agreement or a confidentiality agreement related to such communications. As discussed in our prior publications, the SEC’s Division of Enforcement (Enforcement) has instituted several settled actions against public companies for violating the “chilling effect” provisions of Rule 21F-17. During the past two months, the SEC has filed two additional settled enforcement actions, as summarized below. Thus, as the SEC embarks on the start of its 2017 fiscal year (FY2017), Rule 21F-17 remains an agency-wide priority, and issuers, investment management firms, and broker-dealers—if they have not done so already—need to take heed and proactively remediate any vulnerabilities that they may have regarding their Rule 21F-17 compliance.
OCIE Alerts Registrants
As described previously, the SEC’s most recent annual report stated that assessing confidentiality terms and language for compliance with Rule 21F-17 was a top priority for fiscal year 2016 and that staff had started the practice of examining company documents for such compliance. Now, less than one month into FY2017, OCIE has formalized this practice and notified the registrant community accordingly.
The Risk Alert spells out how OCIE plans to examine documents for these compliance issues. First, OCIE staff will examine whether any terms that are contained in company documents “(a) purport to limit the types of information that an employee may convey to the Commission or other authorities; and (b) require departing employees to waive their rights to any individual monetary recovery in connection with reporting information to the government.” Second, regarding the books and records to be examined, staff will analyze the following types of documents: compliance manuals; codes of ethics; employment agreements; and severance agreements. Finally, the Risk Alert identifies provisions that may contribute to violations of Rule 21F-17 or may impede employees or former employees from communicating with the Commission, such as provisions that:
- require an employee to represent that he or she has not assisted in any investigation involving the registrant;
- prohibit any and all disclosures of confidential information, without any exception for voluntary communications with the Commission concerning possible securities laws violations;
- require an employee to notify and/or obtain consent from the registrant prior to disclosing confidential information, without any exception for voluntary communications with the Commission concerning possible securities laws violations; or
- purport to permit disclosures of confidential information only as required by law, without any exception for voluntary communications with the Commission concerning possible securities laws violations.
Since August 16, 2016, the SEC has instituted two additional enforcement actions for violations of Rule 21F-17 based on prohibitions contained in severance agreements. First, in the Health Net, Inc., matter, the relevant violations involved release language in severance agreements that required employees to waive their right to any monetary recovery resulting from participating in a whistleblower program, among other issues. As part of the settlement, Health Net agreed to pay a $340,000 civil penalty and to engage in undertakings similar to those in the prior Rule 21F-17 cases. A review of the SEC’s Rule 21F-17 stand-alone cases reveals that the penalties have increased with each matter and that Health Net payed the largest fine to date. More recently, and within a month of OCIE’s Risk Alert, an international beverage conglomerate agreed to pay a civil penalty for violations of Rule 21F-17, among other charges. The Rule 21F-17 violations were related to a liquidated damages provision in the company’s separation agreement that did in fact cause an employee to stop communicating with the SEC until he received a subpoena. In this case, the primary charges involved books and records violations and internal control infractions that arose under the terms of the Foreign Corrupt Practices Act of 1977. Consistent with one other Rule 21F-17 case, the SEC appears to routinely investigate possible Rule 21F-17 violations while investigating other charges.
OCIE’s first Risk Alert of FY2017 puts the investment management and broker-dealer industries on notice that OCIE staff will examine and scrutinizing company documents for Rule 21F-17 compliance. More importantly and not stated in the Risk Alert—when coupled with Enforcement’s ongoing and aggressive interest—this combination indicates that OCIE staff will be looking to refer violations of Rule 21F-17 to their receptive Enforcement colleagues. Thus, investment management and broker-dealer registrants need to be proactive in assessing their risks and in reviewing all agreements, policies and procedures that may create exposure to SEC Rule 21F-17 violations. If there are any potential violations, Registrants should then execute a remediation plan. Cleary, this Risk Alert serves as a “notice,” and registrants who fail to act will likely be subjected to an OCIE referral to Enforcement.