A Compilation of Enforcement and Non-Enforcement Actions

21 November 2008 Publication
Author(s): Terry D. Nelson

Legal News: Investment Management Update

New Investment-Related Rules Announced
A number of investment-related rules were recently announced or are imminent. They include such non-enforcement matters as the U.S. Securities and Exchange Commission’s (SEC) proposed requirements for maintaining electronic records; a court ruling regarding the duty of financial institutions to disclose internal incentive programs; The Financial Industry Regulatory Authority, Inc. (FINRA) requirements of arbitrators to make client-requested disclosures of their decisions; FinCen’s withdrawal of anti-money laundering rule proposals for investment advisers; and the SEC’s disclosure of required information in routine on-site examinations of investment advisers. One enforcement action involved the SEC’s penalizing a company’s vice president for violation of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940.


Advisers’ Books and Records to Be Kept Electronically
The Division of Investment Management for the SEC is drafting an amended Rule 204-2 to require investment advisers to keep electronic records. The SEC promulgated Rule 204-2 after the passage of the 1960 amendments to the Investment Advisers Act of 1940. The 1960 amendments provided, in part, that investment advisers must maintain certain records. Since SEC promulgated Rule 204-2 in 1961, the Rule has been amended to provide the option for registered investment advisers to maintain records in a prescribed electronic format.

Although the amended Rule has not yet been drafted, the director of the SEC’s Division of Investment Management, Andrew Donohue, indicated that it would likely require investment advisers to maintain records in electronic format. It also is being contemplated that the electronic format will allow searchable and sortable records of managed accounts, client lists, and ethical breaches.

No Duty to Disclose Internal Incentives
The U.S. District Court for the Southern District of New York recently held that UBS did not violate its disclosure duties when it did not disclose to its customers its internal incentive programs that benefitted certain mutual funds. UBS used a tier system for the mutual funds it offered. According to a putative class of plaintiffs, mutual funds were only placed in the most desirable tier, Tier 1, if the mutual fund families struck a revenue-sharing arrangement with UBS. Financial advisers at UBS then directed clients to invest in Tier 1 funds.

The plaintiffs averred that UBS breached its disclosure duties by failing to disclose this alleged internal incentive program to its customers. Additionally, the plaintiffs maintained that UBS failed to fill out its SEC Form N-1A properly, which requires disclosure if the selection of brokers will be influenced by anything other than receipt of brokerage or research services.

The District Court held UBS had no obligation to disclose the internal incentives program to its customers. Moreover, the District Court held that UBS did not run afoul of its duties under Form N-1A, since it disclosed in its prospectuses that it “might” enter into shelf-space agreements, like the ones alleged to have happened in this case.

Arbitrators Must Explain Decisions Under Proposed FINRA Rule
FINRA recently proposed a rule change that would require arbitrators to complete a detailed description of their decisions upon the request of all parties to the arbitration. Under current rules, the arbitrator is not under any obligation to produce a written explanation of his or her decision. If the SEC adopts the rule change proposed by FINRA, the arbitrator will only have that increased responsibility if so requested by each of the parties involved.

The text of the proposed rule is available online at: http://www.finra.org/web/groups/industry/@ip/@reg/

FinCen Withdraws Anti-Money Laundering Rule Proposals for Investment Advisers
The Financial Crimes Enforcement Network (FinCen) recently announced that it has withdrawn its proposed anti-money laundering rules for certain unregistered investment companies (including many hedge funds), investment advisers, and commodity trading advisors. The proposed rules were first introduced by FinCen for possible adoption in 2002 under the Banking Secrecy Act (BSA). The BSA requires most financial institutions to put anti-money laundering procedures in place.

Until further notice, investment advisers, unregistered investment companies, and commodity trading advisers will not have to establish such procedures.

However, some of these parties already have implemented anti-money laundering provisions, anticipating that FinCen would finalize its rules. Such parties may want to consider maintaining the anti-money laundering procedures if the parties with which it does business (such as broker-dealers, banks, futures commissions, and so forth) require the entity to have anti-money laundering provisions in place as a condition of doing business with or through them.

SEC Provides Insight Into Staff Initial Request for Information in Connection with Investment Adviser Examinations
The SEC’s Office of Compliance Inspections and Examinations (OCIE) recently provided a description of the types of information its staff will request prior to conducting routine on-site examinations of investment advisers. The purpose of providing this information is to inform advisers of the core set of documents the staff will request to understand the adviser’s business, registered compliance risks, and the effectiveness of the adviser’s compliance systems.

The categories of information that the staff includes in its initial request are as follows:

  • Information about the adviser’s business, investment activities, organizational charts, client lists, trade blotter, and description of any litigation or arbitrations
  • Information about the adviser’s compliance program, risk management, internal controls, evidence of the adviser’s self-assessment of its compliance risks, the adviser’s written policies and procedures for addressing those risks, internal audits, and correspondence
  • Documentation of the results of periodic testing performed by the adviser, including forensic and quality control testing results, portfolio management procedures, brokerage arrangements, and procedures for addressing insider trading and conflicts of interest
  • Documentation of actions by the adviser with respect to shortfalls or breaches of its compliance program
  • Information about performance advertising, custody, and financial records

The full text of the SEC’s notice can be viewed at http://sec.gov/info/cco/requestlistcore1108.htm.

Enforcement Actions

Failure to Blow Whistle Resulted in SEC Enforcement
The SEC recently found Wayne Cassaday in violation of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940. Mr. Cassaday served as the president and chief compliance officer of Battery Wealth Management, Inc. (Battery). Albert Parish was a vice president and partial owner of Battery. Mr. Parish fabricated account statements for Battery, borrowed funds from the IRA accounts of Battery’s clients, and issued “IOUs” to Battery’s Loan Pool.

Although Mr. Cassaday was not accused of actively violating the law in the manner that Mr. Parish did, the SEC found that Mr. Cassaday should have realized Mr. Parish was violating the law and causing Battery to violate the law. In fact, Mr. Cassaday was responsible for producing a compliance manual that prevents conflicts of interest like those arising due to Mr. Parish’s actions. Given Mr. Cassaday’s knowledge, he had a duty to act due to his position as chief compliance officer. Mr. Cassaday, however, did not act to prevent Mr. Parish or Battery from violating the law. Mr. Cassaday’s failure to act was, in and of itself, a violation of the Advisers Act. As a result, Mr. Cassaday was personally required to pay a disgorgement of $6,731 and a civil penalty of $40,000.

Foley & Lardner LLP Legal News: Investment Management Update is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this update or would like to discuss this topic further, please contact your Foley attorney or the following:


Terry D. Nelson
Madison, Wisconsin

Joseph D. Shumow
Madison, Wisconsin