Articles Tagged with Rules Regulations

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Written by Peter J. Chess

On November 30, 2011, FINRA and the SEC’s Office of Compliance Inspections and Examinations (OCIE) released a National Exam Risk Alert on effective procedures and policies for broker-dealer branch inspections. This follows other recent guidance for broker-dealers regarding the Market Access Rule and reasonable investigations in Regulation D Offerings, in addition to recent FINRA sanctions against broker-dealers related to Regulation D Offerings.

Under Sections 15(b)(4)(E) and 15(b)(6)(A) of the Exchange Act, the SEC can impose sanctions on any firm or any person that fails to reasonably supervise someone subject to supervision that violates the federal securities laws. A broker-dealer can defend such a charge with a showing of effective procedures and policies designed to prevent and detect potential violations.

The National Exam Risk Alert jointly released on November 30 by FINRA and the OCIE (“November 30 Alert”) concerns broker-dealer branch inspections which are required by the Exchange Act and FINRA rules. Examination staff have observed that firms that execute these inspections well typically:

  • tailor the focus of branch exams to the business conducted in that branch and assess the risks specific to that business;
  • schedule the frequency and intensity of exams based on underlying risk;
  • engage in a significant percentage of unannounced exams selected based on both risk analysis and random selection;
  • deploy sufficiently senior branch office examiners to conduct the examinations; and
  • design procedures to avoid conflicts of interest with examiners.

The November 30 Alert also lists typical findings about firms with deficiencies in their inspection process, including the utilization of generic examination procedures for all branch offices; the use of novice or unseasoned branch office examiners; the performance of “check the box” inspections; and, the lack of adequate procedures and policies.

The November 30 Alert is the second such Alert released this quarter by the OCIE. On September 29, 2011, OCIE released a National Exam Risk Alert  (September 29 Alert) regarding the master/sub-account structure and potential risks of noncompliance for broker-dealers with the recently adopted Rule 15c3-5 (the Market Access Rule).

The Market Access Rule requires broker-dealers to have a system of risk management control and supervisory procedures reasonably designed to manage the financial, regulatory and other risks of the business activity associated with providing a customer or other person with market access. Deficiencies in risk management control and supervisory procedures raise significant regulatory concerns with respect to money laundering, insider trading, market manipulation, account intrusions, information security, unregistered broker-dealer activity, and excessive leverage.

Recent FINRA Enforcement Actions Against Broker-Dealers

On September 29, 2011, FINRA also announced it had sanctioned another eight firms and ten individuals and ordered restitution totaling more than $3.2 million due to violations related to private placements. FINRA previously announced similar sanctions against broker-dealers in April 2011, and the most recent announcement brings the total to ten firms and seventeen individuals sanctioned by FINRA since April for involvement in problematic private placements.

The sanctions stem from a variety of issues uncovered by FINRA related to firms selling private placement offerings, including the lack of a reasonable basis for recommending the offering; failure to conduct a reasonable investigation of the offering; failure to have adequate supervisory systems in place; failure to conduct adequate due diligence of offerings; lack of reasonable grounds regarding the suitability of the offering for customers; and, lack of reasonable grounds to allow registered representatives of firms to continue selling the offerings, despite numerous “red flags.”

These sanctions follow FINRA’s release of a Regulatory Notice in April 2010 (“April 2010 Notice”) regarding the obligation of broker-dealers to conduct reasonable investigations in Regulation D, or private placement, offerings. The April 2010 Notice provided guidance on many of the issues at the heart of the recent sanctions by FINRA related to private placements. The April 2010 Notice noted that broker-dealers had many requirements triggered by private placement offerings, including: a duty to conduct a reasonable investigation concerning the security and the issuer’s representations about it; a duty to possess reasonable grounds to recommend transactions that are suitable for the customer; and, other specific responsibilities that could be triggered based on specific factors with each transaction.

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Written by Ildiko Duckor

An entity that meets the definition of a “Large Trader” after October 3, 2011 must file its initial Form 13H with the SEC by December 1, 2011 to be assigned a large trader identification number (LTID).  The filing is done electronically through the SEC’s EDGAR system.  The LTID must be disclosed to registered broker-dealers effecting transactions on behalf of the Large Trader. 

If you as a general partner or investment adviser (including any entities or individuals over which you have control, e.g., the right to vote or direct the vote of 25% or more of a class of voting securities of an entity) have investment discretion over aggregate transactions in exchange-listed securities that equal or exceed the Identifying Activity Level of: (i) 2 million shares or $20 million during any calendar day or (ii) 20 million shares or $200 million during any calendar month, you may qualify as a Large Trader and may have to file a Form 13H. 

When calculating the “Identifying Activity Level:” (i) aggregate all transactions during the specified period (one day and/or one month) (ii) for all “NMS securities” (national market securities, generally (exchange-listed securities including equities and purchases and sales (but not exercises) of options) and (iii) exclude the specified transactions that are exempt from consideration (as listed in the below-linked documents). 

Form 13H filing is required to be filed annually with the SEC within 45 days after the end of a Large Trader’s full calendar year. 

A full text of the SEC Final Rule and Form 13H is available here.

Please contact the IFIM team for assistance.

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Written by Jay Gould

On November 28, 2011, the SEC charged OMNI Investment Advisors, Inc. of Utah, Feltl & Company Inc. of Minneapolis and Asset Advisors LLC of Troy, Michigan for failing to adopt and implement compliance procedures designed to prevent securities law violations.

The three enforcement actions discussed below should send a clear signal to investment advisers that are already registered and have implemented written compliance policies and procedures, as well as those advisers that will need to register by February 15, 2012, that the SEC is serious about adviser compliance and is willing to make examples of those advisers that do not fully implement a tailored compliance program. 

All three investment advisers, including OMNI’s owner and chief compliance officer Gary R. Beynon, were found to be in violation of the “Compliance Rule” under Rule 206(4)-7 of the Investment Advisers Act and were separately ordered to pay penalty fees and institute a series of corrective measures to settle the SEC charges. 

OMNI and Beynon failed to adopt and implement written compliance policies and procedures, failed to establish, maintain and enforce a written code of ethics and failed to maintain and preserve certain books and records.  Under the settlement, Beynon agreed to pay a $50,000 penalty.  He also agreed to be permanently barred from acting within the securities industry in any compliance or supervisory capacity and from associating with any investment company.  In addition, as part of the settlement, OMNI agreed to provide a copy of the proceeding to all of its former clients between September 2008 and August 2011. 

Feltl & Company failed to adopt and implement written compliance policies and procedures for its growing advisory business.  It further neglected to adopt a code of ethics and collect the required securities disclosure reports from its staff.  Under the settlement, Feltl & Company agreed to pay a penalty of $50,000 and return more than $142,000 to certain advisory clients.  In addition, the firm will hire an independent consultant to review its compliance operations annually for two years, provide a copy of the SEC’s order to past, present and future clients, and prominently post a summary of the order on its website.

Asset Advisors failed to adopt and implement a compliance program.  Asset Advisors adopted policies and procedures after SEC examiners brought it to the firm’s attention, but never fully implemented them. Similarly, Asset Advisors only adopted a code of ethics at the behest of the SEC exam staff and then failed to adequately abide by the code. Under the settlement, Asset Advisors agreed to pay a $20,000 penalty, cease operations, de-register with the Commission, and with clients’ consent, move advisory accounts to a new firm with an established compliance program.

A full text of the SEC release and orders is available here.

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Written by Jay Gould

On Wednesday, November 16, 2011, the SEC charged Morgan Stanley Investment Management (“MSIM”) with violating securities laws in a fee arrangement that costs a fund and its investors approximately $1.8 million in sub-adviser fees.

MSIM is the primary adviser to The Malaysia Fund (the “Fund”), a closed-end investment company that invests in equity securities of Malaysian companies.  AMMB Consultant Sendirian Berhad (“AMMB”) was an SEC registered adviser located in Malaysia.  AMMB is a wholly owned subsidiary of AM Bank Group, one of the largest banking groups in Malaysia.  Pursuant to a Research and Advisory Agreement entered into by the Fund with AMMB and MSIM in 1987, AMMB undertook to provide advice, research and assistance to MSIM for the benefit of the Fund.  Every year AMMB submitted a report to MSIM which MSIM provided to the Fund’s board of directors in its evaluation for the renewal of the advisory and sub-advisory agreements.  The board evaluated and approved AMMB’s sub-adviser agreement based on representations from MSIM that AMMB was providing advisory services to the Fund.  AMMB did not actually provide those advisory services.  MSIM also prepared and filed the Fund’s annual and semi-annual reports to investors that inaccurately represented AMMB’s services. 

The SEC found that “MSIM failed its duty to provide the fund’s board members with the information they needed to fulfill their significant responsibility of reviewing and approving the sub-adviser’s contract.”  In addition, MSIM did not adopt and implement policies and procedures governing the advisory contract renewal process and its oversight of AMMB.

According to the SEC’s order, MSIM willfully violated Section 15(c) and 34(b) of the Investment Company Act and Section 206(2) and (4) of the Investment Advisers Act of 1940, and Rule 206(4)-7 thereunder. 

The SEC ordered MSIM to pay the Fund $1.845 million as reimbursement of the advisory fees the Fund paid to AMMB from 1987 to 2008.  MSIM was also ordered to pay $1.5 million penalty fee.  MSIM agreed to pay over $3.3 million to settle the SEC’s charges. 

A full text of the SEC release and order are available here.

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Written by John L. Nicholson

On October 13, the Securities and Exchange Commission (SEC) Division of Corporation Finance released CF Disclosure Guidance: Topic No. 2 – Cybersecurity (the “Guidance”), which is intended to instruct companies on whether and how to disclose the impact of the risk and cost of cybersecurity incidents (both malicious and accidental) on a company.

This represents a reminder that companies should think about cybersecurity and data breach incidents when deciding how to fulfill their obligations under the SEC’s existing disclosure requirements.  Up to this point, the market’s focus has been on how U.S. law requires disclosure of data breaches affecting personal information of specific types. Other security incidents only became public knowledge because of unofficial disclosures or because of their effect (e.g., a denial of service attack).  Now, the SEC has made it clear that the risks associated with cyber incidents, the costs of mitigating those risks, and the consequences of a cyber incident may rise to the level of materiality that would require disclosure to investors and regulatory authorities.

MORE…

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Written by Jay Gould

On October 18, 2011, the SEC released a notice of FINRA’s filing of Proposed Rule 5123 (the “Proposed Rule”) which would require FINRA members and associated persons to: 1) provide to investors disclosure documents in connection with private placements prior to sale and 2) file with FINRA such disclosure documents within 15 days after the date of first sale and any subsequent amendments.  These proposed changes would significantly affect fund managers who offer or sell their funds that are exempt from registration pursuant to Section 3(c)(1) of the Investment Company Act through third party marketers, nearly all of which are required to be registered as broker-dealers.

Pre-sale requirement to provide disclosure documents to investors

The Proposed Rule would require FINRA members and associated persons that offer or sell private placements or participate in the preparation of private placement memoranda (“PPM”), term sheets or other disclosure documents in connection with such private placements, to provide such disclosure documents to investors prior to sale.  The disclosure documents must describe the anticipated use of offering proceeds, the amount and type of offering expenses, and the amount and type of offering compensation.  Much of this information is currently captured in the Form D filing that most fund managers file with the SEC, but under the Proposed Rule, would go directly to investors in connection with the sale of fund interests.

As a practical matter, this likely means increased scrutiny of hedge fund and other private fund offerings by FINRA, as well as the likelihood that third party marketers that sell on behalf of hedge funds may request greater or more enhanced indemnification from fund managers in the placement agency agreement between the third party marketer and the fund manager.  Accordingly, fund managers who use third party marketers to market their funds must keep their fund documents updated, taking into account all changes to fund strategies, material performance issues (to the extent applicable), regulatory changes and management personnel changes, to name a few.      

Post-sale requirement to notice file with FINRA

The Proposed Rule would also require each FINRA member and associated person to notice file with FINRA by filing the PPM, term sheet or other disclosure documents no later than 15 days after the date of first sale.  In addition, any amendments to such disclosure documents or disclosures required by the Proposed Rule would have to be filed no later than 15 days after such documents are provided to any investor or prospective investor.  To the extent these documents are provided to investors, they would also be subject to the strict liability standard of Rule 206(4)-8 under the Investment Advisers Act to which all fund managers are already subject.  Accordingly, fund managers must be careful to keep all of their documents current under the materiality standards of state and Federal securities laws.

Offerings Exempted from the Proposed Rule

The Proposed Rule would exempt several types of private placements including offerings sold only to any one or more of the following purchasers: 

  •  institutional accounts, as defined in NASD Rule 3110(c)(4);
  • qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;  (Accordingly, 3(c)(7) funds would be exempt from the Proposed Rule.)
  • qualified institutional buyers, as defined in Securities Act Rule 144A;
  • investment companies, as defined in Section 3 of the Investment Company Act;
  • an entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A;
  • banks, as defined in Section 3(a)(2) of the Securities Act; and
  • employees and affiliates of the issuer.

In addition, the Rule would exempt the following types of offerings:

  • offerings of exempted securities, as defined by Section 3(a)(12) of the Exchange Act;
  • offerings made pursuant to Securities Act Rule 144A or SEC Regulation S;
  • offerings of exempt securities with short term maturities under Section 3(a)(3) of the Securities Act;
  • offerings of subordinated loans under Exchange Act Rule 15c3-1, Appendix D;
  • offerings of “variable contracts” as defined in Rule 2320(b)(2);
  • offerings of modified guaranteed annuity contracts and modified guaranteed life insurance policies, as referenced in Rule 5110(b)(8)(E);
  • offerings of non-convertible debt or preferred securities by issuers that meet the eligibility criteria for incorporation by reference in Forms S-3 and F-3;
  • offerings of securities issued in conversions, stock splits and restructuring transactions that are executed by an already existing investor without the need for additional consideration or investments on the part of the investor;
  • offerings of securities of a commodity pool operated by a commodity pool operator as defined under Section 1a(11) of the Commodity Exchange Act; and
  • offerings filed with FINRA under Rules 2310, 5110, 5121 and 5122.

Confidential treatment

Documents and information filed with FINRA pursuant to the Proposed Rule would be given confidential treatment.  FINRA would use such documents and information solely for the purpose of determining compliance with FINRA rules or other applicable regulatory purposes.  In addition, FINRA would afford confidential treatment to any comment or similar letters by FINRA and thus could not be discoverable by a litigant through a legal action.

A full text of the SEC Notice and Proposed Rule is available here.

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Written by Michael Wu

By order released by the SEC on November 10, 2011, Western Pacific Capital Management LLC, a San Diego-based investment adviser, and its President, Kevin James O’Rourke, were charged with fraud for failing to disclose a conflict of interest to clients and materially misrepresenting the liquidity of The Lighthouse Fund LP, a hedge fund they formed and managed. 

Western Capital and O’Rourke urged clients to invest in a security without disclosing that Western Pacific would receive a 10 percent commission. They also failed to register as a broker, failed to provide required written disclosures to clients, improperly redeemed one hedge fund investor’s interest ahead of another’s, and made material misstatements and omissions to clients regarding the fund’s liquidity.  As a result of these conducts, the SEC alleged that Western Capital and O’Rourke willfully violated Section 17(a) of the Securities Act of 1933, Sections 10(b) and 15(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1), 206(2), 206(3), and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 thereunder.

A full text of the SEC release and order are available here.

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Date & Time
11/10/2011
12:30 pm – 7:00 pm PT

12:30 pm – 5:30 pm PT
Workshop
5:30 pm – 6:30 pm PT
Panel and Q&A
6:30 pm PT
Cocktails

Location
Pillsbury’s SF office
50 Fremont Street
San Francisco, CA 94105

Join us for an interactive, instructional workshop to learn step-by-step how to create unique and individualized marketing material to attract and engage investors and raise capital.

Who Should Attend:

  • Emerging Funds Managers
  • Established Funds Managers
  • Hedge Fund Marketers
  • Pre-Launch Managers
  • Fund of Funds Managers

This one day hedge fund marketing event will cover:

  • How to uncover or rebrand your fund identity
  • Defining your marketing message and how to tell it
  • Understanding who your potential investors are
  • How to avoid compliance pitfalls
  • Discovering opportunities that raise capital
  • What investors look for in marketing collateral

and much more…

Presented by
Maital S. Rasmussen,Founder & CEO, Rasmussen Communications, Inc.

Speakers
Ildiko Duckor

Guest Speakers
Rikke Jorgensen, Copywriter, Rasmussen Communications, Inc.
Seavan Sternheim, COO, CMO, QM Capital, LLC

Investor Panel and Q&A Session
Kermit Claytor, Fund of Funds Manager, Skyline Partners
Paul Perez, CFA, Springcreek Advisors, LLC
Ildiko Duckor, Counsel, Pillsbury
T. Jon Williams, Ph.D., CFA, South Avenue Investment Partners

Early Bird$675 for one participant
$975 for two participants
Early Registration ends October 27th, 2011

Regular Price$750 for one participant
$1,050 for two participants

To register, please visit Rasmussen Communications.

Event Contact
Jessica Slater

Sponsors
100 Women in Hedge Funds
California Hedge Fund Association
Rasmussen Communications

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Written by Jay Gould

The Pillsbury Investment Funds Team has over the past month reviewed several new Due Diligence Questionnaire (“DDQ”) forms on behalf of fund manager clients from institutional investors and family offices that contain a new inquiry that is potentially problematic for certain fund managers. Generally, this new inquiry requests information regarding any dispute over fees that the manager has had over a specific time period with certain service providers for the fund and the general partner of the fund. In its typical form, the question asks:

During the past three years, have you [the fund manager] or a controlled affiliate, had any amounts in dispute with or refused payment to any third party marketer or sales agent, any public relations firm or individual conducting a similar function, or any law firm or legal representative?

The DDQ goes on to request additional information about each disputed payment and requests permission from the fund manager for the potential investor to contact the service provider named with respect to the disputed fees. The Pillsbury Investment Funds Team found this question interesting and potentially troublesome and contacted one of the institutional investors with respect to this inquiry. We were informed that this particular investor was concerned that fund managers that do not honor their obligations to service providers are often the same ones that take a broad view regarding the services can be “soft dollared,” manager expenses that are chargeable to the fund, and creative calculations of management and performance fees. We were informed that these particular service providers to fund managers are often not in a position to pursue fees in dispute due to the potential public relations disaster such an action would cause to the allegedly aggrieved party. Or put another way, if a third party marketer brought an action against a fund manager for fees due on assets raised on behalf of a fund, what fund manager would ever retain that marketer again? Institutional investors are also concerned about the continuity of service providers and any pattern related to why high or constant service provider turnover. It is worth noting that auditors are not generally included in this type of question because changing auditors and the reason for it is covered in a separate inquiry. It is our understanding that this addition to the DDQ is gaining popularity among institutional investors and family offices and that follow up on the information provided in response to the inquiry is being conducted.

This development raises several potential issues for fund managers that are asked to respond to this inquiry. First, all responses to DDQs and other “marketing” materials are subject to the fiduciary standard set forth in Investment Advisers Act Rule 206(4)-8 which was adopted in 2007 in response to the Goldstein decision. Rule 206(4)-8 applies to every investment adviser, whether or not registered, and imposes a strict liability fiduciary standard on information that is provided to investors and potential investors. Accordingly, to the extent a fund manager refuses to answer the DDQ or does not answer the question fully and truthfully, such manager faces a potential violation of Section 206 of the Investment Advisers Act, which is a very serious offense. Additionally, to the extent a potential investor seeks to obtain information regarding legal fees in dispute, fund managers should be aware that they are being asked to waive the attorney client privilege with respect to this aspect of the relationship with their attorneys. Fund managers should seek to condition disclosure of this information on confidentiality, however, it is likely that such information could still be obtained from the investor by way of a subpoena from the Securities and Exchange Commission, a state regulator, or even a third party litigant.

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Written by Jay Gould, Ildiko Duckor and Michael Wu

An investment adviser must ensure that its IARD account is adequately funded to cover payment of all applicable registration renewal fees and notice filing fees.  Beginning November 14, 2011, Preliminary Renewal Statements (“PRS”), which list an adviser’s renewal fee amount, are available for printing through the IARD system.  By December 9, 2011 (Friday), an investment adviser should have submitted to FINRA through the IARD system, its preliminary renewal fee.  Any additional fees that were not included in the PRS will show in the Final Renewal Statements which are available for printing beginning January 3, 2012.  All final renewal fees should be submitted to FINRA through the IARD system by February 3, 2012.   Please note that all renewal fees must be submitted for deposit to an adviser’s IARD “Renewal” Account.

For more information about the 2012 IARD Account Renewal Program including information on IARD’s Renewal Payment Options and Addresses, please follow this link: http://www.iard.com/renewals.asp

Please contact us if you have questions.