Articles Tagged with SEC

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The Securities and Exchange Commission (SEC) yesterday adopted a series of amendments to the rules that govern money market funds.  The most controversial of these amendments will require institutional prime and tax-exempt money market funds to maintain a floating net asset value (NAV) and will allow the boards of institutional and retail prime and tax-exempt money market funds to impose liquidity fees and to suspend redemptions temporarily if the funds’ weekly liquid assets fall below a certain threshold.  Funds will have two years to comply with these amendments.

Retail and government funds will be not subject to the floating NAV requirement.  A retail fund is defined as a fund that has policies and procedures reasonably designed to limit all beneficial owners to natural persons.  A government fund is defined as a fund that invests 99.5% of its assets in cash and government securities.  Floating NAVs will be rounded to the fourth decimal place.  In conjunction with the SEC amendments, the Treasury Department and the Internal Revenue Service proposed rules providing a simplified tax accounting method to track gains and losses on floating NAV money market funds and providing relief from the wash sale rules.

If a money market fund’s weekly liquid assets fall below 30% of its total assets, a fund board would be permitted to impose a liquidity fee of up to 2% on redemptions and to suspend redemptions (impose a “gate”) for up to 10 business days.  If the liquid assets fall below 10%, the fund would be required to impose a liquidity fee of 1%, unless the fund board determines that a lower or higher fee (ranging from no fee to a 2% fee) would be in the best interest of the fund.  Government funds would not be subject to these requirements, but could voluntarily opt into them if previously disclosed to investors.

Concern has been expressed that the floating NAV requirement will impose new costs on money market funds, prompt institutional investors to shift cash to government funds, bank deposits and unregulated funds, and impair the short-term funding of businesses and governments.  Concern has also been expressed that the liquidity fee and gate requirements will trigger runs.

The SEC at the same time adopted less controversial amendments to the diversification, disclosure and stress testing requirements for money market funds, as well as to the reporting requirements for money market funds and for private funds that operate like money market funds.  In addition, it reproposed amendments to remove references to credit ratings in the rules and forms relating to money market funds.

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The Securities and Exchange Commission (the “SEC”) charged Kevin McGrath, a partner at a New York investor relations firm with insider trading.  According to the SEC complaint, McGrath allegedly received confidential information from clients in order to prepare press releases.  The SEC discovered McGrath used non-public information from two different clients to buy or sell such clients’ securities for his personal benefit.

While high dollar insider trading cases are common news, this case involves profits of a mere $11,776.  The financial penalties were similarly small and McGrath settled the case with a disgorgement of $11,776, interest of $1,492 and a penalty of $11,776, in addition to a prohibition on trading in any client security.  Those with access to insider information should see this case as a reminder that no instance of insider trading will be ignored by the SEC.

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Private equity firms were put on notice last year that they may be subject to registration as broker dealers when David Blass, head of the Division of Markets and Trading at the Securities and Exchange Commission (“SEC”), provided his insights at an industry conference.  Since that time, the SEC has published their examination priorities list, which included the presence exams of new registrants, a portion of which would review that status of private equity fund managers under the broker dealer rules.  Following up on this warning to the industry, the SEC has also targeted unregistered brokers for enforcement action.

Recently, at a speech in front of another industry group, Mr. Blass provided further guidance on how a private equity firm might structure its compensation arrangements in order to avoid the need to register as a broker dealer.  Consistent with the advice that Pillsbury has been providing private fund clients for many years, Mr. Blass warned against paying “transaction based” compensation and further suggested that if a private fund employee has “an overall mix of functions,” and sales is one aspect of those duties, it is less likely that the SEC staff would view such an arrangement as one that would require broker dealer registration.  An employee of a private fund manager would not be prohibited from being compensated on the overall success of the firm, and certainly sales of fund securities contribute to that overall success.  But tying compensation to assets raised looks like the traditional broker dealer compensation and should be avoided.

Mr. Blass indicated that the SEC is close to finalizing guidance on issues connected to private fund manager employee compensation.  However, the SEC staff has further to go before providing guidelines to the industry on the broker dealer registration issues posed by deal fees that private equity firms sometimes collect on transactions.  It is unlikely that Mr. Blass will see his initiatives through to completion, as he will soon be joining the staff of the Investment Company Institute where he will one day lobby against his former positions.

If you would like additional background on how the private fund managers came to find themselves in the gray zone of broker dealer registration as a result of paying their employees for performance, you may want to re-visit this article.

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In a move that should place securities lawyers and their clients on notice, Commissioner Kara Stein of the Securities and Exchange Commission (“SEC”) recently indicated that lawyers may become targets of SEC enforcement actions when a registrant has been poorly advised by its attorney and the result of that advice ends up harming investors or violating regulatory standards.  The SEC has the ability to sanction, fine and bar attorneys and accountants from practicing before the SEC pursuant to SEC Rules of Practice 102(e).  As a practical matter, a bar pursuant to Rule102(e) precludes an attorney or an accountant from representing a regulated entity, such as an investment adviser or broker dealer, in any further dealings with the SEC or otherwise.

Several years ago, before he retired, I asked Gene Gohlke, then the acting head of the SEC’s Office of Compliance, Inspections and Examinations, why it was that the SEC brought Rule 102(e) proceedings against accountants, but rarely against attorneys.  “Lawyers are different,” was the answer I received.  And that has been the approach  of the SEC for quite some time, only bringing proceedings to bar attorneys in the most obvious and egregious cases.  My question to Mr. Gohlke was prompted by what I saw as questionable legal advice from certain “boutique” law firms that were providing not just aggressive advice, but simply incorrect advice.  You may recall that before the relatively recent Mayer Brown no-action letter, hedge fund managers were being advised that they could hire third party marketers that were not registered as broker dealers through “solicitation agreements” pursuant to Rule 206(4)-3 under the Investment Advisers Act of 1940.  This position, which was advocated by every former real estate or anti-trust  lawyer turned hedge fund lawyer, was flatly wrong, but generally embraced by fund managers.  When the SEC finally caught on that some fund managers were hiring unregistered broker dealers, Bob Plaze, then associate director of the Division of Investment Management of the SEC, somewhat famously quipped that if fund managers had been interpreting the Dana letter to allow such activity, they had been interpreting it wrong.

Additionally, in his recent speech, David Blass put fund managers on notice that they have been misinterpreting the scope of the “issuer’s exemption,” Rule 3a4-1 under the Securities Exchange Act of 1934.  Fund managers are now on notice that they need to either hire third party brokers, or pay their internal employees based on something other than the amount of capital raised on behalf of the fund.  This also grew out of a misunderstanding of that rule by the aggressive and misinformed section of the securities bar.  There are many other examples, such as relying on the “issuer’s exemption” when the fund is organized as a unit trust, rather than a partnership or exempted company (don’t do it), misinterpretation of what constitutes permissible use of soft dollars within the safe harbor Section 28(e), operation of the custody rule, execution of short sales, and many more.  When the SEC finds deficiencies in a fund management organization, it is typically the fund manager that suffers the consequences, not the attorney that advised the fund management company.

But with the SEC now identifying attorneys as key “gatekeepers,” all of that could change.  Commissioner Stein is “troubled greatly” by enforcement cases where the lawyers that gave advice on the transaction and prepared and reviewed disclosures that were relied upon by investors are not held accountable.  The Commissioner identified that when lawyers do provide bad advice, or effectively serve to assist fraud, their involvement is used as a shield against liability, both for themselves and for others.  The problem has been surfaced by the SEC, now we will see how and against whom enforcement action is taken in order to make an example for the industry.

What does this mean for fund managers?  First, fund managers need to recognize that “forum shopping” is dangerous.  You can always find a lawyer somewhere that is complacent, desperate, or unethical enough to tell the fund manager whatever they want to hear.  This is a short term folly and can only lead to a bad result in the longer term.  Second, the market has changed substantially since the heady days of 2002-2007.  It is no longer just the overworked and understaffed regulators with which fund managers need to concern themselves.  Investor sophistication in the due diligence area has increased substantially and now endowments, family offices and ultra-high net worth investors want to understand that the fund manager has made good decisions with respect to their service providers and has not opted for a low-end option that the fund manager can dominate and control.  Particularly for start-up fund managers that have essentially one shot at executing on a successful offering, the choice of an administrator that has no FATCA solution, or a lawyer that is unknown or not respected, can kill the offering before it ever gets started.  As attorneys, we recognize that competition in the asset management business is fierce and raising assets has rarely been more difficult; however, this is a business that is built on trust and confidence.  Fund managers need to demonstrate with every decision they make; they are motivated by the best interests of their investing clients.

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The Commodity Futures Trading Commission (“CFTC”) staff recently issued guidance to registered CPOs regarding the delegation of commodity pool operator (“CPO”) functions from persons that might otherwise be subject to CPO registration.  For non-natural persons delegating CPO functions to a registered CPO, the relief from registration is conditioned on the CPO that is delegating its authority (the “Delegating CPO”) controlling, being controlled by, or being under common control with, the registered CPO (the “Designated CPO”).  The new staff letter removed the previous requirement that “unaffiliated directors” of the commodity pool that would be considered CPOs agree to be jointly and severally liable with the registered CPO for violations of the Commodity Exchange Act or the CFTC‘s regulations by the registered CPO.  This new no-action relief is not self-executing.  Each Delegating CPO must apply to the CFTC in order to take advantage of this new CFTC staff position.

In order to coordinate filing obligations for the CFTC and the Securities and Exchange Commission (SEC), many CPOs, which may also be registered investment advisers, seek to delegate their obligations to affiliated commodity trading advisors or registered CPOs.  Information provided in Form PF may be used to fulfill portions of the filing requirements for Form CPO-PQR under CFTC regulations, if the same entity is filing both reports.  However, previous CFTC guidance on this point was ambiguous at best. The new staff letter is meant to provide clear and consistent guidance for when CPO delegation will be permitted, but will not adversely affect no-action relief that was previously granted under the former CFTC position.

The new staff letter sets forth specific criteria for the approval of CPO delegations. The criteria in the new CFTC letter for obtaining CFTC delegation approval are as follows:

  • The Delegating CPO must have delegated to the Designated CPO all of its investment management authority with respect to the commodity pool pursuant to a legally binding document.
  • The Delegating CPO must not participate in the solicitation of participants for the commodity pool or manage any property of the commodity pool.
  • The Designated CPO must be registered as a CPO with the CFTC.
  • The Delegating CPO must not be subject to a statutory disqualification.
  • There must be a business purpose for the Designated CPO being a separate entity from the Delegating CPO other than solely to avoid the Delegating CPO registering with the CFTC.
  • The books and records of the Delegating CPO with respect to the commodity pool must be maintained by the Designated CPO in accordance with CFTC Regulation 1.31.
  • If the Delegating CPO and the Designated CPO are each a non-natural person, then one must control, be controlled by, or be under common control with the other.
  • Delegating CPOs that are (i) non-natural persons or (ii) board members other than “unaffiliated board members” must execute a legally binding document with the Designated CPO in which each party undertakes to be jointly and severally liable for any violation of the Commodity Exchange Act or the CFTC’s regulations by the other party in connection with the operation of the commodity pool.
  • “Unaffiliated board members” that are Delegating CPOs must be subject to liability as a Board member in accordance with the laws under which the commodity pool is established.

The new staff letter itself includes a form of no-action request that a Delegating CPO would file with the CFTC, including identifying information about the Delegating CPO and the Designated CPO, and certifications by the Designated CPO and Delegating CPO regarding satisfaction of the criteria set forth in the new staff letter. Unfortunately, the no-action letter request must be submitted pursuant to the process set forth in CFTC Regulation 140.99 in paper form instead of by e-mail.

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

On March 10, 2014, Financial Industry Regulatory Authority, Inc. (“FINRA”) submitted a proposed rule to the Securities and Exchange Commission (“SEC”) that would require disclosure to certain clients and FINRA regarding the details of a broker-dealer representative’s financial recruiting incentives (the “Proposed Rule”). The Proposed Rule is intended to ensure that the former clients of a representative who has changed firms are aware of: (i) the recruitment compensation that induced the representative to change firms, and (ii) all of the costs and potential risks associated with transferring their assets to the new firm (the “Recruiting Firm”). In addition to disclosures to clients, the Proposed Rule would require the Recruiting Firm to report to FINRA at the beginning of a representative’s employment, any significant total compensation increases the representative will receive in the first year, compared to the representative’s compensation the prior year.

Under the Proposed Rule, if a Recruiting Firm directly or through the representative, tries to induce the representative’s clients from a prior firm to transfer assets to the Recruiting Firm, the Recruiting Firm would be required to disclose to the potential client if the representative has received, or will receive, $100,000 or more in either (i) aggregate “upfront payments” or (ii) aggregate “potential future payments.” Upfront payments include compensation received upon commencement of association or specified amounts guaranteed to be paid at a future date (e.g. cash, deferred cash bonus, transition assistance, forgivable loans, equity awards, loan-bonus arrangements, or ownership interests. Potential future payments include those offered as a financial incentive contingent upon the representative meeting performance-based goals, allowance for additional travel or expense reimbursement in excess to what is typical for similarly situated representatives, or a commission schedule for a representative who is paid on a commission basis in excess of what is typically provided to similarly situated representatives.  Where the Recruiting Firm partnered with another entity, such as an investment adviser or insurance company, to recruit a representative, the disclosed upfront payments and potential future payments would include any payments from those third parties connected to the recruitment.

The amount of recruitment compensation received would be disclosed separately for aggregate upfront payments and aggregate potential future payments using ranges for each: $100,000 to $500,000; $500,001 to $1,000,000; $1,000,001 to $2,000,000; $2,000,001 to $5,000,000; and above $5,000,000. In addition to the amounts that must be disclosed, the Recruiting Firm would be required to disclose the basis for determining the upfront and potential future payments. Pursuant to the Proposed Rule, disclosure would not be required to be disclosed to clients that meet the definition of an “institutional account” under FINRA Rule 4512(c), however accounts held by natural persons would not qualify for the institutional account exception under the Proposed Rule.

Client disclosures, pursuant to the Proposed Rule, would also be required to include whether transferring assets from the representative’s prior firm to the Recruiting Firm would cause the client to incur any costs the Recruiting Firm would not reimburse. Further, if the assets are not transferrable, the Recruiting Firm would be required to disclose the costs the client may incur, including taxes.

The Proposed Rule would require the disclosures be made to the client at the time of first individualized contact by the representative or Recruiting Firm that attempts to convince the client to transfer assets. Written disclosures would be required if the contact is in writing. If the contact is oral, the disclosures would be made orally with written disclosures to follow. The disclosure requirement would be mandated for the representative’s first year with the Recruiting Firm.

The second component of the Proposed Rule would require the Recruiting Firm to report to FINRA if it reasonably expects the total compensation paid to the representative, in his/her first year, to increase the representative’s prior year’s compensation by the greater of 25% or $100,000. The compensation information reported to FINRA would not be available to the public under the Proposed Rule.

The SEC will review the Proposed Rule and is expected to seek public comment. The Proposed Rule has not yet been published on the SEC’s website as of the date of this posting.

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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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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.