Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors

On July 14, 2016, RiverFront Investment Group, LLC (“RiverFront”) agreed to settle charges brought by the SEC for failing to “properly prepare clients for additional transaction costs beyond the ‘wrap fees’ they pay to cover the cost of several services bundles together.” Press Release No. 2016-143. According to the SEC, participants in wrap fee programs usually pay an annual fee “which is intended to cover the cost of several services ‘wrapped’ together, such as custody, trade execution, portfolio management, and back office services.” Release No. 4453. The SEC found that under these wrap programs, a sponsoring firm will offer clients a selection of third-party managers, referred to as subadvisors, to have discretion over the clients’ investment decisions. When subadvisors execute trades on behalf of clients through a sponsor-designated broker-dealer, the transaction costs associated with the trades are included in the wrap fee. On the other hand, if a subadvisor sends a trade to a non-designated broker-dealer, a practice known as “trading away,” clients incur additional transaction costs beyond the wrap fee. Continue reading “Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors”

SEC Uses Books and Records and Internal Control Regulations to Extend Reach of Actions Beyond Fraud

Last year, we predicted that the SEC would increase its use of administrative proceedings to enforce strict liability violations such as books and records and internal controls. See Mary P. Hansen & William L. Carr, The Future of SEC Enforcement Actions: Negligence Based Charges Brought in Administrative Proceedings, The Investment Lawyer, Vol. 21, No. 9 (September 2014). In a recent action, announced on April 1, 2015, the SEC did just that.

According to the SEC, Timothy Edwin Scronce, the majority owner and CEO of privately held TelWorx Communications, LLC (“TelWorx”), falsified TelWorx’s books to inflate its revenues leading up to and after the acquisition of TelWorx by a public company, PCTEL, Inc. (“PCTEL”). Exchange Act Rel. No. 74626 (Apr. 1, 2015). In particular, prior to the acquisition, Scronce directed TelWorx’s Controller, Michael Hedrick, to inflate the value of certain inventory and to invoice certain orders before they had shipped and then reverse the invoices so they could be invoiced again during the subsequent quarter. After the acquisition, Scronce instructed Hedrick to create dummy invoices for orders that Scronce himself intended to make to further conceal his conduct. In addition, once Scronce learned that a large order that had been postponed would not be placed in time to help meet the quarterly results, he instructed the Vice President of Sales and Tech Services, Marc J. Mize, to solicit a straw vendor that would purchase the product on an intermediate basis with the intent to prematurely recognize the income from this sale. The timing on this transaction ultimately would not obtain the benefit Scronce intended, and he instructed Mize and another employee to reverse the invoice and to enter a revised, false purchase order into the system. All of these actions caused PCTEL to materially overstate its income during the relevant period.

Based on these allegations, the SEC instituted proceedings against Scronce for violation of (1) “Section 10(b) of the Exchange Act and Rule 10b-5 thereunder which prohibit fraudulent conduct in connection with the purchase or sale of securities”; (2) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (3) “Section 13(a) of the Exchange Act and Rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading”; (4) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (5) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act.” Without admitting or denying the findings, Scronce agreed to disgorgement in the amount of $376,007; prejudgment interest in the amount of $29,212.47; and a civil monetary penalty in the amount of $140,000, and to a ten-year ban on acting as an officer or director of any issuer.

The SEC did not stop there, though. It also charged Hedrick and Mize for violation of (1) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (2) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (3) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act,” none of which requires the SEC to prove that an individual acted with scienter. In addition, the SEC charged Hedrick with causing Scronce’s violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder and with causing “PCTEL’s violations of Section 13(a) of the Exchange Act and rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading.”

Hedrick and Mize, like Scronce, agreed to resolve the charges without admitting or denying the findings. Each of them agreed to pay civil monetary penalties in the amount of $25,000. Notably, these sanctions do not reflect that Hedrick was charged with causing Scronce’s and PCTEL’s fraud violations, while Mize was only charged with strict liability violations.

We expect the SEC to continue using books and records and internal control charges to pursue companies and senior executives who play a role in fraudulent schemes, even where an individual did not act intentionally or even recklessly.

SEC’s Broken Window Enforcement Program Gets a Boost from “Quantitative Analytics” and “Algorithms”

The SEC announced last week that it had charged, in settled administrative proceedings, 28 individuals and investment firms that failed to “promptly report information about their holdings and transactions in company stock” and six public companies that contributed to “filing failures by insiders or fail[ed] to report their insiders’ filing delinquencies.” See SEC Press Release: “SEC Announces Charges Against Corporate Insiders for Violating Laws Requiring Prompt Reporting of Transactions and Holdings.” The SEC obtained a total of $2.6 million in civil monetary penalties as a result of the filed charges. The individual amounts ranged from $25,000 to $150,000. These cases are the latest example of the SEC’s focus on strict liability violations of the federal securities laws.

All of the charges arise under Sections 13(d), 13(g), and 16(a) of the Securities Exchange Act of 1934. These sections require certain forms to be filed, irrespective of profits or the reasons for engaging in the stock transactions. Although the SEC does not need to establish that an individual or company engaged in insider trading (nor was there any finding that would suggest such) in order to prove any of the charged violations, legislative history indicates that Section 16(a) was motivated by a belief that “the most potent weapon against the abuse of inside information is full and prompt publicity” and by a desire “to give investors an idea of the purchases and sales by insiders[,] which may in turn indicate their private opinion as to prospects of the company.”

Pursuant to Section 16(a) and Rule 16a-3, company officers, directors, and certain beneficial owners of more than 10% of a registered class of a company’s stock (“insiders”) are required to file initial statements of holdings on Form 3 and to keep this information current by reporting transactions on Forms 4 and 5. Specifically, within 10 days after becoming an insider, the insider must file a Form 3 report disclosing his or her beneficial ownership of all securities of the issuer. To keep this information current, insiders must file Form 4 reports disclosing purchases and sales of securities, exercises and conversions of derivative securities, and grants or awards of securities from the issuer within two business days following the execution date of the transaction. In addition, insiders are required to file annual statements on Form 5 within 45 days after the issuer’s fiscal year-end to report any transactions or holdings that should have been, but were not, reported on Form 3 or 4 during the issuer’s most recent fiscal year and any transactions eligible for deferred reporting (unless the corporate insider has previously reported all such transactions).

Beneficial owners of more than 5% of a registered class of a company’s stock must use Schedule 13D and Schedule 13G to report holdings or intentions with respect to the respective company. According to legislative history, Section 13(d) is a key provision that allows shareholders and potential investors to evaluate changes in substantial shareholdings. The duty to file is not dependent on any intention by the stockholder to gain control of the company, but on a mechanical 5% ownership test. A Schedule 13D must be filed within ten days of the transaction, and a Schedule 13G must be filed within 10 to 45 days of the transaction, depending on the category of filer and the percentage of acquired ownership. Importantly, Section 16(a) also requires an investment adviser to file required reports of behalf of funds that it manages when the fund’s ownership or transactions in securities exceed the statutory thresholds.

Under Section 16(a), public companies are required to disclose in their annual meeting proxy statements or in their annual reports, “known” Section 16 reporting delinquencies by its insiders. This disclosure is commonly referred to as the Item 405 disclosure. The Item 405 disclosure of any late filings or known failures to file must (i) identify by name each insider who failed to file Forms 3, 4, or 5 on a timely basis during the most recent fiscal year or prior fiscal years and (ii) set forth the number of late reports, the number of late-reported transactions, and any known failure to file. An issuer does not have an obligation under Item 405 to research or make inquiry regarding delinquent Section 16(a) filings beyond the review specified in the item. Although insiders remain responsible for the timeliness and accuracy of their required Section 16(a) reports, the SEC has encouraged companies to assist their officers and directors to submit their filings, or even to submit the required form on the insiders’ behalf to ensure accurate and timely filing.

These actions make clear, however, that reliance on the company does not excuse violations as the insider retains ultimate responsibility for the filings. The majority of the charged individuals told the SEC that their delinquent filings resulted from the failure of the company to make timely filings on their behalf. In one case, disclosures in the company’s annual proxy statements relating to Section 16(a) compliance revealed that the filing of the insider reports was late because of “lack of staffing,” “late receipt of necessary information,” and “a change in the processing of these forms and delays caused by an email server malfunction.” The SEC still charged the insider because the insider took “ineffective steps to monitor whether timely and accurate filings were made” on his or her behalf by the company.

Without providing any details, the SEC claimed that it used “quantitative analytics” or algorithms to identifyindividuals and companies with especially high rates of filing deficiencies. The SEC’s filing of these actions underscores its willingness to devote resources to pursuing strict liability violations. It also demonstrates the SEC’s efforts to use quantitative analysis and algorithms to identify violations and to streamline the investigative process.