A Compilation of Enforcement and Non-Enforcement Actions

17 November 2010 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

SEC to Develop New Exam Process for Registered Investment Advisers and Broker-Dealers

The SEC is still smarting from the criticism it received in the wake of the Bernard Madoff Ponzi scheme that went undetected during SEC exams. In an effort to ensure that a Madoff-type scheme does not go undetected, the SEC will soon introduce new features to its exam process for registered investment advisers and broker-dealers. The revamped SEC exam process will include interviews or other involvement with senior management and board members of the registrant.

The SEC’s Office of Compliance Inspections and Examination (OCIE) is currently conducting a thorough review of its examination process. It expects to complete the review and implement new exam policies by the end of this calendar year. Earlier this year, OCIE reported on its new risk-based examination process, which requires the examiners to conduct extensive research of the registrant and its business before conducting the onsite examination.

During the pre-exam research process, the staff will focus on the following elements:

  1. The independence of legal and compliance departments and officers
  2. The adequacy and effectiveness of compliance and risk functions/processes and controls
  3. The level of senior management engagement in compliance and risk processes, and whether there is an appropriate compliance “tone” at the top of the firm
  4. Whether the board is engaged and focused on risk management
  5. The adequacy and independence of internal audits

OCIE now has a new centralized unit for risk assessment that will work with the SEC’s Office of Market Intelligence to coordinate follow-up on tips and complaints received by the SEC. The data collected will be used by OCIE to help assess risk and determine which firms to examine. OCIE examiners, who will receive training once the new exam policies are complete, will focus on registrants and business practices where problems persist. For investment advisers, persistent problem areas found by the SEC during onsite examinations include conflicts of interest, portfolio evaluation, portfolio management, and whether the disclosures within Part II of Form ADV match up to the registrant’s method of business.

Finally, OCIE is working with the SEC’s Division of Risk, Strategy, and Financial Innovation and the Division of Investment Management to develop an exam program for hedge funds, which is to be in place by July 2011.

FINRA Proposes Broker-Dealer Conflict-of-Interest Disclosures to Customers

Registered investment advisers have always been required by the SEC to provide their clients with written disclosure about conflicts of interest. Investment advisers are a fiduciary with respect to providing investment advisory services to their clients. Disclosure about conflicts of interest is implicitly required as a fiduciary. Now, the Financial Industry Regulatory Authority (FINRA) has proposed that broker-dealer member firms of FINRA disclose, in writing to their non-institutional customers, conflicts of interest prior to providing services to such customers.

This FINRA initiative comes on the heels of the passage of the Dodd-Frank Wall Street Reform and Consumer Protect Act, which requires the SEC to, among other things, conduct a study on what obligations broker-dealers have to their customers and make rules establishing fiduciary duties for broker-dealers. This proposal appears to be FINRA’s attempt to stay out in front of likely SEC action in this area.

FINRA’s proposal would require broker-dealers to provide a disclosure statement to their retail (i.e., non-institutional) customers listing the types of accounts and services available, the fees associated with each account and service, whether fees are negotiable, incentives the broker-dealers or its representatives have for recommending certain products, investment strategies or services, conflicts that the broker-dealer has with its customers, and how the broker-dealer proposes to handle those conflicts. In addition, the written disclosure would have to detail any limitations on the duties the broker-dealer owes its customers.

FINRA is asking for comments on its proposal to determine if it is too broad or too narrow and how the broker-dealers may be able to correspond its disclosure statement to customers (including by electronic means) without unduly confusing customers with unnecessary and/or overwhelming information.

Comments on the proposal must be submitted by December 27, 2010. After that, the proposed rule would have to be approved by the SEC. The proposal can be reviewed in its entirety online at http://tinyurl.com/2bdcb7d.

SEC Issues Interpretive Letter on Duties of Mutual Fund Directors

The SEC has issued an interpretive letter on the duties of mutual fund directors under the Investment Company Act that should help fund boards reduce the volume of quarterly review materials for their directors by relying on summary quarterly reports prepared by the fund’s chief compliance officer or other designated persons.

The letter addresses the responsibilities of mutual fund directors in reviewing certain conflict-of-interest transactions under Rule 17a-7 (allows certain purchases from and sales to affiliated funds), Rule 17e-1 (provides guidance for the use of affiliated brokers for portfolio transactions), and Rule 10f-3 (allows certain purchases from affiliated underwriting syndicates). Each of these rules requires a fund board to make a determination, no less frequently than quarterly, that each transaction made during the preceding quarter was effected in compliance with procedures reasonably designed to provide that the transactions comply with the requirements of the relevant rule. While the letter makes it clear that a fund board cannot delegate its responsibility to make the required determinations, it expressly states that directors do not have to review each transaction in order to make the required determinations.

Instead, mutual fund boards may make these determinations based on summary quarterly reports (prepared by the fund’s chief compliance officer or other designated persons) of the transactions effected in reliance on the applicable rule. Of course, even if a fund board relies on summary quarterly reports to help reduce the volume of quarterly review materials, directors remain responsible for ensuring that they properly discharge their fiduciary duties.

Specifically, one of the basic fiduciary duties that the law imposes on mutual fund directors is a duty of care. In the context of conflict-of-interest transactions, the duty of care requires that directors fully understand the issues raised by these conflict-of-interest transactions. Therefore, directors need to remain vigilant even if they do rely on summary quarterly reports, and they need to ensure that they have a process in place that is reasonably designed to ensure that conflict-of-interest transactions are effected in a manner that is consistent with the board-approved procedures and the relevant rules.

Investment Advisers to Mutual Funds Encouraged to Adopt Social Media Policies

The use of social media, such as Facebook, MySpace, LinkedIn, and so forth, is widespread for both work and personal purposes. While social media can foster connections between colleagues, employees, and friends, and allow the sharing of information quickly, the information posted to social media is in the public domain and may reflect on the business of investment advisers and the mutual funds that they manage. To ensure that the use of social media does not negatively affect the adviser and the funds, the adviser should adopt a social media policy.

While a social media policy must be tailored to each investment adviser and the mutual funds that it manages, there are some key items that any such policy should address:

  • The policy should provide that supervised persons of the investment adviser, as well as any supervised persons of the mutual funds, are not permitted to divulge the name of the adviser or the fund or their position on social media, except for professional networking sites (e.g., LinkedIn).
  • If a supervised person elects to use the name of the investment adviser or the mutual funds on LinkedIn and identifies himself or herself as an employee of the adviser or the funds, the policy should provide that they must refrain from (1) making any disclosures that may harm the adviser or the funds, (2) misrepresenting their job title or position, or (3) posting negative comments. This should include not permitting “online friends” to post comments or recommendations to a supervised person’s social media, which may include the comments/recommendations of current and former employees of the adviser or the funds.
  • The policy should provide that supervised persons of the investment adviser and the funds are prohibited from providing a referral, reference, or endorsement for current or former employees of the adviser or the funds.
  • The policy should provide that supervised persons of the investment adviser or the mutual funds should not use the e-mail function on any social media site when communicating information that would be required to be retained under securities laws.
  • The policy should prohibit the posting of any privileged or non-public information on social media about both the advisers’ business activities and clients or any business activities of the funds.

As an additional safeguard, the social media policy may provide that any information that a supervised person intends to place on social media about the investment adviser or the mutual funds must be pre-approved by the chief compliance officer or his or her designee. In any event, the chief compliance officer or his or her designee should regularly review any information that supervised persons are placing on social media about the adviser or the funds.

Enforcement Matters

Hedge Fund Managers Charged by the SEC in the Use of “Side Pockets”

Demonstrating the SEC’s concerns over the abusive misuse of side pockets by hedge fund managers, the SEC filed suit in October 2010 in the U.S. District Court for the Northern District of Georgia (SEC v. Mannion, N.D. Ga., Civil Action No. 10-CV-3374, 10/19/10) against two hedge fund managers and their investment advisory firm for allegedly using a side pocket to overvalue assets.

A side pocket is typically used by a hedge fund manager to separate assets from the rest of the hedge fund assets that may be particularly illiquid investments. Segregating the assets allows the investment manager some flexibility in dealing with the assets and paying off investors from those assets. The SEC suspects that side pockets are often used as a dumping ground to conceal overvalued assets. The main concern by the SEC is that fees collected for the management over those assets are too high based on the inflated values.

In this case, the SEC alleges that the hedge fund managers deposited certain assets in a side pocket and valued them in “a manner that was inconsistent with the fund’s policy and contrary to undisclosed internal assessment.” According to the SEC, the valuation of these assets allowed the investment manager to collect inflated fees and stave off investor redemptions. The SEC also alleges that the fund managers stole approximately $1.6 million of securities that belong to the fund and used investors’ cash intended for the fund for their own personal use.

Counsel for the defendants expressed disappointment with the SEC for filing the charges some five years after the alleged events took place.

The SEC has asked the court to issue an injunction, ordering disgorgement plus interest and civil penalties.

The use of side pockets and side letters by hedge fund managers is an area of enhanced scrutiny by SEC staff and will likely continue to be a target of SEC examinations and enforcement actions.

Department of Labor Moves Against Investment Firms in Madoff Fraud

The United States Department of Labor (DOL) filed a lawsuit against several New York investment management firms and their principals who provided advice to pension plans that invested with Bernie Madoff (Solis v. Beacon Associates LLC, S.D.N.Y., No. 10-CV-8000, 10/21/10).

The lawsuit alleges a breach of fiduciary duties under ERISA when they recommended investments with Mr. Madoff in the midst of several red flags that should have caused them to question Mr. Madoff. The breach of fiduciary duties, according to DOL’s lawsuit, caused dozens of ERISA plans to lose hundreds of millions of dollars.

DOL’s lawsuit follows numerous lawsuits that have been filed against some of these same defendants. In October 2010, a court provided an initial favorable ruling involving one of these lawsuits, leaving intact most of the ERISA breach of fiduciary duty claims.

DOL’s lawsuit asks the court to require the defendants to pay for all plan losses and to return any fees and profits. Finally, the SEC has asked the court to permanently bar the defendants from serving as fiduciaries for ERISA plans.


Legal News is part of our ongoing commitment to providing legal insight to our clients and colleagues. If you have any questions about or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:

Terry D. Nelson
Madison, Wisconsin

Peter D. Fetzer
Milwaukee, Wisconsin