Articles Tagged with Investment Advisers

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As we have previously reported, the Securities and Exchange Commission (“SEC”) has taken a significantly heightened interest in whether people who engage in certain promotional activities on behalf of issuers of securities should be subject to regulation as a broker dealer.  The David Blass speech of April 5, 2013 put hedge fund general partners on notice that certain sales practices undertaken by hedge fund personnel may require registration as a broker dealer.  The SEC has recently followed up this guidance with enforcement action.

On May 15, 2014, the SEC  charged a Tiburon, California based securities salesman for selling millions of dollars in oil-and-gas investments without being registered with the SEC as a broker-dealer or associated with a registered broker-dealer.  The defendant, Behrooz Sarafraz, agreed to settle the SEC charges by paying disgorgement of his commissions, prejudgment interest, and a penalty for a total of more than $22 million.

According to the SEC’s complaint filed in federal court in San Francisco, Sarafraz acted as the primary salesman on behalf of TVC Opus I Drilling Program LP and Tri-Valley Corporation, which were based in Bakersfield, California.   From February 2002 to April 2010, these companies raised more than $140 million for their oil-and-gas drilling venture.  While Sarafraz was raising money for these entities, he was not associated with any broker-dealer registered with the SEC.  The SEC also alleged that Sarafraz worked full-time locating investors for the Opus and Tri-Valley oil-and-gas ventures.  He described the investment program to investors and recommended they purchase Opus partnership interests or securities of Tri-Valley and its affiliated entities.  In return, Sarafraz received commissions that ranged from seven to 17 percent of the sales proceeds that he and members of a sales network generated.  The SEC alleges that Opus and Tri-Valley paid Sarafraz approximately $18.3 million in sales commissions.  He paid approximately $1.9 million to others as referral fees and kept the remaining $16.4 million for himself.

For the two companies for which Sarafraz raised money, this could be just the beginning of the process.  If investors have lost money or would otherwise seek to unwind these transactions, it is possible that the investors could sue the companies and Sarafrax for rescission.  Typically, in a rescission recovery case, the plaintiffs who purchased through the unregistered broker can receive the higher of the current market price of the price that they originally paid for the securities.  Hedge funds and other private companies that use solicitors should take note.

The SEC also charged New York-based Rafferty Capital Markets with illegally facilitating trades for another firm that was not registered as a broker-dealer as required under the federal securities laws.  According to the SEC’s order instituting settled administrative proceedings, Rafferty agreed to serve as the broker-dealer of record in name only for approximately 100 trades in asset-backed securities that were actually introduced by the unregistered firm.  While Rafferty held the necessary licenses and processed the trades, it was the unregistered firm that managed the business.  Five of the firm’s employees became registered representatives with Rafferty but they performed their work in the offices of the unregistered firm, which retained sole authority over their trading decisions and determined their compensation.  Rafferty had no involvement in the trading or compensation decisions while the registered representatives executed the trades through Rafferty’s systems on behalf of the unregistered firm.  Based on the agreement, Rafferty kept 15 percent of the compensation generated by these trades and sent the remaining balance to the unregistered firm.

The SEC’s order found that Rafferty willfully violated Federal securities laws and also willfully aided and abetted and caused the unregistered broker-dealer’s violation of the registration provisions of the Securities Exchange Act.  Rafferty consented to a cease-and-desist order that censures the firm and requires the disgorgement of $637,615 as well as payment of $82,011 in prejudgment interest and a $130,000 penalty.  This case should serve as a cautionary tale for hedge fund and other private fund managers that seek to hire sales people who construct sham arrangements with a broker dealer in order to appear to be in compliance with the broker dealer registration provisions.  Expect more of these types of action from the SEC in the near future.

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The Securities and Exchange Commission (“SEC”), on March 31, 2014, announced insider trading charges against two men who allegedly traded on information they overheard from their respective wives.  On April 3, 2014, the SEC announced charges against two friends who traded tips related to an impending acquisition deal.  The spouse cases and friend cases differ with respect to the culpability of the tipper.  In the friend cases, the tipper and the tippees were all aware that they were breaching their duties to maintain the information and not trade on it.  In the spouse cases, the wives were unaware of their husbands’ intentions and actions and had previously informed their husbands of the prohibition on trading on any information gleaned from them.

Friends

The SEC has charged three friends who worked together to trade on nonpublic information related to the acquisition of The Shaw Group by Chicago Bridge & Iron Company.  John W. Femenia was employed by a major investment bank from which he obtained the information about the impending acquisition.  Femenia told his friend Walter D. Wagner the nonpublic information and Wagner passed that information along to Alexander J. Osborn.  Osborn and Wagner proceeded to invest substantially all of their liquid assets based on the information from Femenia.  When the public announcement was made, Wagner and Osborn profited approximately $1 million collectively.

Femenia was charged in December 2012 for knowingly being the source of nonpublic information to a whole insider trading ring.

Wagner settled with the SEC by disgorging all illicit profits and a parallel criminal action against him was announced on April 3rd. The SEC case against Osborn is ongoing.

Family

The SEC charged two men with insider trading, in unrelated cases, for illegally trading on information they obtained from their wives. In each case, the husband overheard his wife on a business call in which market moving information was discussed. The SEC found that both men were aware of the prohibition on trading on the information obtained from their spouses and knowingly violated the duty and profited from the information.

Both men have settled their cases with the SEC and each has agreed to pay more than double the profits realized.

The lessons from these cases apply to any person who may obtain material nonpublic information about public entities that they have a duty to protect. Investment advisers and broker-dealers should be sure their insider trading training and policies address the friends and family issue directly. Employers should remind their employees to be cognizant of who can overhear their phone conversations or potentially see their written communication with clients or co-workers and take as many precautions as practicable to prevent the insider information from being used illegally.

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The U.S. Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) previously announced that its 2014 Examination Priorities included a focus on technology, including cybersecurity preparedness.  In connection with that statement of examination priority, OCIE recently issued a Risk Alert to provide additional information concerning its initiative to assess cybersecurity preparedness in the securities industry.

As part of this initiative, OCIE will conduct examinations of more than 50 registered broker-dealers and registered investment advisers focused on the following:

  • the entity’s cybersecurity governance,
  • identification and assessment of cybersecurity risks,
  • protection of networks and information,
  • risks associated with remote customer access and funds transfer requests,
  • risks associated with vendors and other third parties,
  • detection of unauthorized activity, and
  • experiences with certain cybersecurity threats.

OCIE has provided a sample form of request for information and documents that investment advisers and broker dealers can expect to receive prior to this type of examination.

Although the SEC has stated that they believe the sample document request (see Appendix) should help to empower compliance professionals with questions and tools they can use to assess their firms’ level of preparedness, registrants should also expect the SEC to use the sample document as a basis for finding deficiencies, to the extent the guidance is not followed.

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Written by: Ildiko Duckor

The California Commissioner of Business Oversight (“Commissioner”) recently amended California’s custody rule 10 C.C.R. Section 260.237 (the “New Custody Rule”).  The New Custody Rule will be effective on April 1, 2014.

All investment advisers licensed or required to be licensed in California must comply with the New Custody Rule.  California Exempt Reporting Advisers are not affected.

What is “having custody?”

Holding or having authority to obtain possession of client funds or securities, for example:

  • Possession of client funds or securities unless received inadvertently and returned to the sender promptly.
  • Any arrangement (such as a general power of attorney) that authorizes you to withdraw client funds or securities maintained with a custodian by instructing the custodian.
  • Any capacity with authority to access to client funds or securities (such as general partner of a limited partnership, managing member of a limited liability company or trustee of a trust).

If you “have custody” of assets.

  • Qualified Custodian.  You must maintain those assets with a “qualified custodian” such as a bank, trustee, or prime broker.
  • Notice on ADV.  You must notify the Commissioner on your ADV that you have or may have custody.
  • Notice to Clients*. You must notify your client in writing of the custodian’s name and address, and the manner in which the assets are maintained, and any changes to this information.
  • Quarterly Custodian’s Account Statement*.  You must reasonably ascertain that the custodian sends quarterly account statements with specific information to each client (for example, by being cc-d on electronic statements the custodian sends).
  • Surprise Exam*.  You must retain a CPA (by written agreement) to have an annual “surprise exam” of client assets, and report the examination and any resignation of the CPA on your ADV.
  • Internal Control Report.  If you or your affiliate serves as the qualified custodian:
    • The CPA firm conducting the surprise exam must be registered with and subject to examination by the PCAOB.
    • You must obtain an annual internal control report with specified content.
  • Exceptions.  There are certain exceptions from some of the New Custody Rule’s requirements for mutual fund shares, certain private securities, and for advisers that “have custody” only because they deduct fees (if certain conditions are also satisfied).

Fund Managers’ Obligations.

If you are a general partner of an investment limited partnership or a managing member of a limited liability company (or are in a similar position with respect to a pooled fund vehicle):

  • Quarterly Investor Account Statement.  You must send to all fund investors quarterly account statements showing:
    • the total amount of all additions to and withdrawals from the fund,
    • a listing of all additions to and withdrawals from the fund by an investor,
    • the opening and closing value of the fund at the end of the quarter,
    • the total value of an investor’s interest in the fund at the end of the quarter, and
    • a listing of securities positions on the closing date of the statement pursuant to FASB Accounting Standards Codification 946-210-50-4 through 6.
  • Independent Expense Verification*.  You must retain (by written agreement) an independent accountant or attorney obligated to act in your investors’ best interests and send him/her all invoices or receipts with details regarding calculations, so the independent person can:
    • review all fees, expenses and withdrawals from the fund,
    • determine that payments conform to the fund agreement, and
    • forward to the custodian approval for payments of the invoices.
  • Audited Fund Exceptions*.  You need not comply with the following requirements:  Notice to Clients, Quarterly Custodian’s Account Statement, Surprise Exam and Independent Expense Verification; if:
    • Your fund is audited annually, in accordance with GAAP, by an independent CPA registered with and subject to examination by the PCAOB.
    • The audited financials are distributed to all investors and the Commissioner within 120 days of the end of the fund’s fiscal year.
    • A final liquidation audit is performed, in accordance with GAAP, upon the fund’s liquidation, and the audited financials are distributed to investors and the Commissioner promptly upon completion of the audit.
    • The independent CPA is required by agreement to notify the Commissioner on Form ADV if it resigns or is terminated.
    • You notify the Commissioner that you intend to use the audit exception route.

For further details and interpretation of the intricacies of the New Custody Rule as they apply to you, please contact your Pillsbury Investment Funds and Investment Management team member.

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Written by:  Jessica M. Brown and Michael G. Wu

On March 10, 2014, the U.S. Commodity Futures Trading Commission and the Financial Services Agency of Japan signed a Memorandum of Cooperation which expresses the agencies’ intent to work together to supervise and oversee regulated entities that operate on a cross-border basis in Japan and the United States.  The agencies intend to cooperate in the interest of their respective derivative market regulations. The full text of the Memorandum can be found here.

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Written by:  Jay B. Gould and Jessica M. Brown

The Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations released a “Risk Alert” on January 28, 2014, which focuses on the due diligence investment advisers perform in alternative investments[1] and managers for their clients. After observing an increasing trend in advisers recommending alternative investments to their clients, the SEC examined a group of SEC-registered investment advisers, who collectively manage more than $2 trillion. The purpose of the examination and the Risk Alert is to review how the advisers perform due diligence, utilize investment teams to review fund structures and complex investment strategies, and identify, control and disclose conflicts of interest.

While the Risk Alert focuses on the narrow market segment of advisers who recommend to their clients discretionary investments in alternative investments managed by outside advisers/managers, the recommendations and due diligence practices can serve as practical guidance for all investment advisers and fund managers.

Observations

The SEC notes four primary trends in the due diligence that advisers perform on alternative investments and their managers:

  1. Position-level transparency and client risk mitigation
  2. Use of third parties to supplement and validate information provided by managers
  3. Quantitative analyses and risk measures on the investment and managers
  4. Enhancing and expanding due diligence teams and policies

Warning Indicators

The SEC notes a number of red flags that advisers find with respect to managers that warrant additional due diligence. These warning signs include:

  • managers who refuse transparency requests;
  • performance returns that conflict with factors known to be associated with the manager’s strategy;
  • unclear investment and research process;
  • lack of a sufficient control environment and separation of duties between the business and investment units;
  • portfolio holdings that conflict with a purported strategy;
  • insufficiently knowledgeable personnel to carry out the strategy intended to be implemented;
  • changes in manager investment style;
  • investments that are overly complex or opaque;
  • lack of third-party administrator;
  • inexperienced auditor;
  • repeated changes in service providers;
  • unfavorable background check results;
  • discovery of undisclosed conflicts of interest;
  • insufficient compliance or operational programs; and
  • lack of sufficient fair valuation process.

Advisers should review whether their due diligence process identifies these warning indicators and whether there are additional warning indicators they should consider to meet their fiduciary obligations. 

Adviser Compliance Practices

The SEC identifies the areas in which they found material deficiencies or control weaknesses with the investment advisers. Based on the deficiencies the SEC identifies, advisers who recommend alternative investments should ensure:

  • the due diligence policies and procedures for alternative investments/managers are reviewed annually;
  • disclosures made to clients do not deviate from actual practices, are consistent with fiduciary principles and describe any notable exceptions to the adviser’s typical due diligence process;
  • marketing materials are not misleading or unsubstantiated regarding the scope and depth of the due diligence process;
  • due diligence processes are written policies that contain sufficient detail and require adequate documentation; and
  • if responsibilities are delegated to third-party service providers, periodic reviews of those service providers’ adherence to their agreements.

Conclusion

The SEC reminds advisers that they are fiduciaries and must act in the best interest of their clients. In order to meet their fiduciary obligations when selecting alternative investments for clients, an adviser must evaluate whether such investment meets the client’s investment objectives and is consistent with the strategies and principles of investment presented to the adviser by the manager.

While the Risk Alert focuses on a narrow market segment of advisers, the recommendations and due diligence practices have a broader application. Any SEC-registered adviser, exempt reporting adviser or state-registered adviser can review their own operational due diligence policies and procedures to see if they can be bolstered by incorporating any of the recommendations contained in the Risk Alert. Further, managers of alternative investments should consider whether any of their practices or policies are included in the list of warning indicators and make the changes necessary to smoothly pass an adviser’s due diligence process.

[1] Included in the SEC’s definition of “alternative investments” are hedge funds, private equity funds, venture capital funds, real estate funds, funds of private funds, and other private funds.

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The annual affirmation process started on December 3, 2013. Advisers who relied on an exemption or exclusion from CPO registration under CFTC Regulation 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), 4.13(a)(5) or an exemption from CTA registration under 4.14(a)(8) and filed a notice with the NFA must affirm the exemption or exclusion annually within 60 days after the end of the calendar year. Failure to affirm the exemption or exclusion will result in the exemption or exclusion being withdrawn at the end of the affirmation period. Accordingly, those who filed a notice of exemption or exclusion in 2013 have until March 3, 2014 to affirm the exemption or exclusion or face losing their exemption or exclusion. Those who filed a notice of exemption or exclusion during the affirmation period of December 3, 2013 to March 3, 2014 will not need to affirm until the 2014 calendar year end. To obtain information about the annual affirmation process and filing, please visit the NFA website.

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Written by:  Jessica M. Brown

The Securities and Exchange Commission charged a registered investment adviser and its principal for making false claims over social media regarding their inflated performance claims with respect to a mutual fund managed by the adviser. Through a Twitter account and a widely circulated newsletter, Mark A. Grimaldi and Navigator Money Management (NMM), made various false statements in order to solicit more business. Grimaldi will pay a $100,000 penalty and, along with NMM, agree to be censured, obtain an independent compliance consultant and cease and desist from committing future violations.

A full text of the SEC press release is available HERE and the SEC order is available HERE.

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Written by:  Jessica M. Brown

The Securities and Exchange Commission (“SEC”) and the United States Department of Labor (“DOL”) announced sanctions today against Western Asset Management Company (“Western Asset”), a subsidiary of Legg Mason.  Western Asset is an SEC-registered investment adviser and reported $442.7 billion in assets under management as of September 30, 2013.

The SEC found Western Asset breached its fiduciary duty to certain ERISA clients when it failed to efficiently correct a coding error that caused losses to over 100 ERISA clients, and did not disclose the error for over two years.  The coding error caused an off-limit private investment to be allocated to the ERISA accounts, and such investment declined significantly in value before the error was discovered.  Western Asset concealed the error rather than reimburse the clients as it was obligated to do under its error correction policy.  In addition to other sanctions for the disclosure violations, Western Asset must distribute approximately $10 million to the harmed ERISA clients.  Further, Western Asset must pay a $1 million civil penalty in the SEC settlement and an additional $1 million penalty in the DOL settlement.

Western Asset was also found to have engaged in prohibited cross trades during the financial crisis.  Instead of crossing the securities at the average price between the bid and the ask price, Western Asset crossed the securities at the bid price.  As a result, the full benefit of the market savings was allocated to the buying clients and the selling clients lost out on approximately $6.2 million in savings.  Pursuant to a separate order settling the cross trade charges, Western Asset must distribute approximately $7.44 million to the clients who were harmed by the illegal cross trading, pay a $1 million penalty in the SEC settlement, and a $607,717 penalty in the DOL settlement.

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Written by: Jessica M. Brown

As a result of recent amendments made by the U.S. Department of Treasury to the Treasury International Capital Form B (“Form B”), private funds and investment advisers may be required to file Form B.  Form B requires a fund manager or investment adviser to report certain information concerning “claims” and “liabilities” of the reporting institution to or from foreign residents.

Filing obligations may arise for private funds that provide credit to foreign entities, invest directly in foreign debt instruments, directly hold foreign short-term securities, or have a foreign credit facility.  Claims or liabilities that are serviced by a U.S. entity or held by a U.S. custodian or subcustodian, do not need to be reported.  Claims or liabilities with a foreign subsidiary or affiliate of a U.S. entity (such as a swap counterpart) are reportable on Form B.  Investment advisers are required to report on behalf of the funds they manage and U.S. funds are not required to report on their own behalf.

There are a number of different Form B reports and generally advisers or managers with total claims or liabilities under $50 million in all geographical regions, or $25 million in an individual country, are exempt from filing.  Detailed filing requirements and descriptions of each Form B can be found here.

The Federal Reserve Bank of New York (the “NY Fed”) requires investment advisers who have reportable claims or liabilities to report this information on certain monthly and quarterly reports. Reportable claims and liabilities as of December 31, 2013, must be reported by January 15, 2014 on the first monthly report, by January 20, 2014 for the first quarterly report. 

The NY Fed will grant extensions and determine appropriate filing deadlines on an individual basis and encourages new filers to contact them.

Please contact us immediately if you have any questions.