A Compilation of Enforcement and Non-Enforcement Actions

31 January 2013 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters 

  • FINRA Announces Regulatory and Examination Priorities for 2013 
  • SEC Previous Hedge Fund Enforcement Trends for 2013

Enforcement Matters 

  • Another “Cherry-Picking” Enforcement Action Brought by the SEC

Non-Enforcement Matters

FINRA Announces Regulatory and Examination Priorities for 2013

At the beginning of each year, the Financial Industry Regulatory Authority (FINRA) announces its regulatory and examination priorities for the year. The priorities are based on FINRA’s current assessment of both investor protection needs and market issues. The following represents the 2013 regulatory and examination priorities for business conduct and sale practices, as recently published by FINRA:

  • Suitability and Complex Products. FINRA Rule 2111 requires broker-dealers and their associated persons to make suitable recommendations to their customers. FINRA considers this a priority area due, in large part, to the complexity of some of the investment products currently being recommended to customers. FINRA is concerned that the associated persons may not fully understand the complexities of such products and would not be able to fully explain the products to customers, especially the full extent of the risks involved in such investments. Listed by FINRA as those product areas that are being recommended by broker-dealers and their associated persons that will be the subject of heightened review by FINRA examiners include investments in business development companies (BDCs), leveraged loan products, commercial mortgage-backed securities (MBS), high-yield debt instruments, structured products, exchange traded funds and notes, non-traded REITs, closed-end funds, municipal securities, and variable annuities. Investments recommended in these types of securities will be examined by FINRA to determine, among other things, if they were suitable investments and the associated person’s level of knowledge about the product. 
  • Cyber Security and Data Integrity. FINRA is concerned about cyber-security issues within the financial services industry and whether its member firms have adequate controls to protect customer data during cyber attacks and data security breaches. 
  • Microcap Fraud. Microcap and low-priced securities traded over-the-counter are often hyped by stock price manipulators. FINRA expects to examine its members to determine if they have adequate policies and controls to ensure that any activities by their associated persons in such securities are in full compliance with suitability and other FINRA provisions. 
  • Private Placement Offerings. FINRA recently implemented Rule 5123, which is intended to keep FINRA more informed about member firms’ participation in private offerings. The Rule requires member firms to file a copy of the private placement offering memorandum with FINRA to the extent that such a memorandum was utilized in the offering and sales were conducted with retail investors. FINRA is concerned about the level of due diligence conducted by member firms prior to the placement and the suitability of such investments for retail investors. 
  • Anti-Money Laundering. FINRA believes that member firms generally need to be more vigilant for suspicious activity with respect to money laundering activities. FINRA will examine the level of due diligence conducted and whether the member firm has an adequate review process for suspicious activity. 
  • Branch Office Supervision. FINRA will especially review those branch offices of member firms that have, in the past, exhibited inadequate supervision over sales practices and where a significant number of associated persons who are located there have disciplinary history. 
  • Insider Trading. Capturing most of the financial service industry headlines during the past year or so have been the enforcement actions by regulatory authorities against member firms, associated persons, and others in trading on material non-public information. FINRA will examine to determine if member firms have adequate policies and procedures in place to safeguard material non-public information that comes into their possession. 
  • Financial and Operational Priorities. FINRA will examine in this area, among other things, whether member firms have sufficient net capital to fund operations and otherwise meet regulatory capital requirements, margin lending practices, leverage and liquidity, and for any guarantees and/or contingencies taken on by the member firm. 
  • Market Regulation. Due to the increasing complexity of the financial services industry and its products, FINRA wants especially to review those areas where market integrity may be in question. Namely, FINRA will focus on algorithmic trading, high-frequency trading, the use of alternative trading systems (ATS), the proper use of order origin codes for options transactions, the misreporting or non-reporting of open positions in options, and best execution, inter-positioning, and fair pricing in the fixed-income market.

SEC Previews Hedge Fund Enforcement Trends for 2013

Not to be outdone by FINRA (see article above), the SEC often uses the first of the year to announce its priorities for examinations to be conducted within the investment management sector for the upcoming year. In a recent presentation by Bruce Karpati, Chief of the SEC’s Enforcement Division’s Asset Management Unit (AMU), the following represent the priority areas for AMU’s enforcement and inspection agenda for 2013.

The AMU’s primary focus is on hedge funds and investment advisers to such funds and other alternative investments and private funds. In order to more effectively conduct examinations of such funds and their advisers, the AMU has recently hired professionals from the hedge fund and alternative investment industry to help conduct the exams. According to Mr. Karpati, “They know where the bodies are buried.”

During the past three years, the SEC has initiated more than 100 enforcement actions against hedge fund managers. With the AMU’s newly acquired expertise in the operations of such funds and their management, the number of enforcement actions is likely to increase in 2013. The main type of violations cited within these actions involved conflicts of interest, valuation, performance, and compliance and controls.

According to Mr. Karpati, the AMU will focus more closely on private equity fund advisers that are at higher risk for fraudulent behavior (based on performance data of hedge fund advisers that raises unusual or extraordinary results). In addition, it appears that the AMU will focus on those private fund advisers who have less than $150 million in assets under management and are not otherwise required to be registered as investment advisers under the Investment Advisers Act of 1940.

Mr. Karpati recommended certain steps that hedge fund and other private fund managers could take to ensure that they fulfill their fiduciary duties and avoid SEC enforcement actions. He reminds managers that they need to have a culture of compliance throughout their operations and employees, coupled by effective and written policies and procedures. He also stresses the need to provide compliance personnel adequate authority, management support, and time to do an effective job. Finally, such managers need to prepare for the inevitable AMU examination.

Enforcement Matters

Another “Cherry-Picking” Enforcement Action Brought by the SEC

In the December 2012 edition of our Investment Management Update, we reported on an SEC enforcement matter involving a hedge fund manager who “cherry picked” investments over the interests of its clients. This past month, the SEC settled an enforcement matter (In the Matter of Middlecove Capital, LLC and Noah L. Myers, Investment Advisers Act of 1940 Release No. 3534 January 16, 2013), which included similar allegations against a Connecticut-based investment advisory firm and its principal owner and chief investment officer.

At its peak, the firm, which is no longer registered as an investment adviser under the Advisers Act, had about $129 million of assets under management for more than 350 clients. During the adviser’s existence, it was not uncommon for the firm to trade for its own account alongside its client accounts. However, for a period of about two and a half years, the adviser engaged in a cherry-picking scheme in which its own and those of the firm’s principals’ accounts were allocated profitable trades and client accounts were allocated unprofitable trades. During that period of time, one of the principal’s trading accounts had a track record where 95 percent of the trades were profitable, a result that could only suggest fraudulent conduct. According to the SEC’s calculations, time and time again, clients lost money in the same positions when the adviser’s and its principals’ accounts profited or did not lose money from trades in such positions.

This matter was recently settled when the respondents agreed to a cease and desist order from engaging in fraudulent behavior under the Securities Exchange Act of 1934 and the Advisers Act, a bar imposed on the firm’s principal from association with, among others, any investment adviser, and from acting or serving as an employee, officer, director, or member of an investment adviser or investment company. The firm and its principal also were ordered to pay disgorgement of $462,022 plus interest of $26,096 and a civil penalty of $300,000.

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

Michael G. Dana
Miami, Florida