A Compilation of Enforcement and Non-Enforcement Actions

27 February 2013 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters 

  • Registered Investment Advisers’ Annual Review of Compliance Policies and Procedures 
  • Mutual Fund Boards and Oversight of Fair Valuation 
  • Mutual Funds and Affiliated Securities Lending Agents

Enforcement Matters 

  • CFTC Takes Enforcement Action Against Introducing Broker for Lying to the Regulator 
  • SEC Takes Enforcement Action Against Adviser for Inadequate Written Compliance Policies and Procedures 
  • Financial Adviser Charged With Illegally Providing Insider Information

Non-Enforcement Matters

Registered Investment Advisers’ Annual Review of Compliance Policies and Procedures

Under Rule 206(4)-7 of the Investment Advisers Act of 1940, SEC-registered investment advisers are required, at least annually, to review the adequacy of their compliance policies and procedures and assess their effectiveness. While compliance with this Rule makes sense for the investment adviser in order to avoid an enforcement action by the SEC for non-compliance (see the article below, “SEC Takes Enforcement Action Against Adviser for Inadequate Written Compliance Policies and Procedures”), it also makes good business sense for the adviser to periodically evaluate, and improve upon, the effectiveness of its compliance policies and procedures.

During the year, material changes in the business activities or personnel of the adviser, compliance matters that arose, or regulatory changes that occurred will require the adviser to carefully evaluate those changes and events and determine if its compliance policies and procedures adequately address those changes and events on a going-forward basis. More than likely, the careful evaluation will conclude that some changes in the firm’s policies and procedures are necessary.

In order to properly conduct the compliance review and assessment, the adviser needs to dedicate sufficient time to conduct the review and assessment and delegate to the appropriate personnel the charge of performing and reporting the review and assessment results to management. The personnel appointed to conduct the review and assessment are typically supervised by the firm’s chief compliance officer, who should have first-hand knowledge of the changes that occurred during the year. Equally important as the conduct of the review and assessment is the need for the adviser to maintain a record of the annual compliance review and assessment, how it was conducted and by whom, the deficiencies noted within the policies and procedures, and how each deficiency was addressed. Without such a record, the adviser will have difficulty convincing the SEC that the required review and assessment was ever conducted.

The compliance policies and procedures review and assessment, if conducted efficiently, can be a benefit to the adviser and its conduct of business. For example, client complaints received during the year may be an indication of a systematic problem that needs to be addressed. Each client complaint should be reviewed by the appropriate personnel not only to appropriately address the client’s complaint and resolve it fairly but also to determine whether the complaint reveals a systemic problem, such as a lack of effective supervision over a particular portfolio manager or business segment of the adviser. If the compliance review of each complaint is not conducted in this fashion, then the annual compliance assessment is a good opportunity to determine if the complaints received during the year indicate a systematic problem or a personnel problem that still needs to be addressed. The adviser’s careful assessment of the client complaints and the reasons that caused them to occur will help avoid such complaints from occurring in the future. Such avoidance will help eliminate costly resolutions, which can only be a plus for the adviser’s business.

A turnover of key personnel or material change of business activities of the firm could require necessary changes in the firm’s compliance policies and procedures. For example, the addition during the year of a portfolio manager who brought in a significant number of new clients may require a greater amount of supervision than long-time portfolio managers with a history of effective and compliant client management with the firm. Also, if the adviser added during the year one or more private funds that it offers to clients, such activities raise additional and different compliance issues than the business of just managing separately managed accounts. All such changes need to be evaluated during the compliance assessment process to determine if the existing compliance policies and procedures adequately address such changes. More than likely, some revisions will be required.

As part of its annual review and assessment, the adviser should consider the SEC’s announced “hot topic” areas that the SEC examiners find troublesome when they conduct examinations of registered advisers. Those areas include accurate valuation of client assets, maintaining the confidentiality of a client’s private information, disclosure of, and measures to deal with, conflicts of interest between the adviser and its clients, adequacy of insider trading controls, and the adequacy of private fund management and accurate reporting to fund investors. Also, as part of the annual review and assessment, the adviser should review the adequacy of its code of ethics, business continuity and disaster recovery plans, and “pay-to-play” practices.

Finally, the results of the annual review and assessment and recommendation to address deficiencies or concerns should be promptly presented to the adviser’s management for consideration and possible implementation. Any approved changes to the firm’s compliance policies and procedures then need to be included, as appropriate, within the firm’s written policies and procedures manual. Failure by the adviser to carry out this compliance review and assessment in a thoughtful and efficient manner would not only be in violation of Rule 206(4)-7 and lead to possible enforcement action against the adviser and its principals by the SEC, but just as important, would result in a missed opportunity to address issues that may be adversely affecting the adviser’s business and bottom line.

Mutual Fund Boards and Oversight of Fair Valuation

In a recent newsletter, we reported on the enforcement action that was brought against eight former members of the boards of directors overseeing five Memphis, Tennessee-based mutual funds for violating their asset pricing responsibilities under the federal securities laws. This article expands on the key takeaways related to the enforcement action, and highlights some lessons learned from prior enforcement actions related to fair valuation.

According to the SEC’s order instituting administrative proceedings against the eight directors, the directors delegated their fair valuation responsibility to a valuation committee without providing meaningful substantive guidance on how fair valuation determinations should be made. The SEC further asserts that the fund directors made no meaningful effort to learn how fair values were being determined, and received only limited information about the factors involved with the funds’ fair value determinations.

We do not believe that the enforcement action stands for the proposition that boards of directors must approve or ratify every fair value determination, nor that the board must itself formulate the fair value pricing procedures. Indeed, in a letter to the Investment Company Institute dated December 8, 1999, the Staff of the SEC stated that, in complying with their obligations under the Investment Company Act, directors may review and approve pricing procedures formulated by fund management. We believe the real message is that boards cannot blindly assign fair valuation responsibility to a committee or the investment adviser. Instead, this assignment must be made in a manner that ensures the committee or the investment adviser understands what is expected of it, and that ensures the board will continue to have regular and meaningful oversight of the process.

Key action items for boards of directors include: (1) reviewing fund pricing policies and procedures on a regular basis to ensure (a) that they specify (to the extent practicable) acceptable pricing sources and pricing methodologies for each significant category of asset held by the fund that might require fair valuation and (b) that they address requirements for the approval of pricing methodologies that will be used internally by the fund’s investment adviser; and (2) when securities are being fair valued, ensuring that the board receives a report regarding these securities that provides sufficient information for the board to understand the pricing methodology that is being used.

Directors also should be cognizant of the following pitfalls: 

  • Directors should be careful not to overlook information indicating that the fair valued prices being used are no longer reliable. For example, in one enforcement action, the SEC found that a board did not follow up on pricing issues when presented with specific information about deteriorating credit quality and questions concerning the liquidity of high-yield bonds held in a fund’s portfolio. 
  • Directors should ensure that they do not approve fair valued prices that are based on valuation methodologies that are inconsistent with SEC guidance. For example, in one case, an administrative law judge found that a thinly traded security was fair valued based on the price expected to be received in a subsequent active market, rather than the price that would be received in the current market. 
  • Directors should not ignore specific information made available to them concerning an issuer’s current financial condition and future prospects. For example, in one case, an administrative law judge found that directors did not adequately consider the security’s delisting from a stock exchange, the issuer’s bankruptcy proceedings, and the issuer’s consistent failure to meet management’s income projections. 
  • Directors should not continue to rely on prices provided by a pricing service when they are given information indicating that these prices do not reflect the fair value of the securities. For example, in one case, the SEC found that directors should have instructed the fund’s pricing committee to stop using a vendor’s prices after the directors were advised by the fund’s portfolio manager that the vendor’s prices were inaccurate. 
  • Directors should not approve fair valuation policies and procedures and consider their jobs done, rather than being alert for circumstances indicating that the procedures are not being followed. For example, in one enforcement action, the SEC found that directors failed to follow up on their requests for information from the investment adviser when the directors were on notice of problems with the prices of the fund’s securities.

Mutual Funds and Affiliated Securities Lending Agents

Shareholders of a family of exchange-traded funds have brought suit against the ETFs’ investment adviser and trustees for allegedly excessive compensation paid to a securities lending agent affiliated with the investment adviser. The plaintiffs argue primarily that the fee split between the ETFs and the affiliated securities lending agent harmed shareholders by “siphoning off securities lending profits” for the benefit of the affiliated securities lending agent at the expense of the ETFs. They allege that the ETFs received 60 percent of securities lending income, that the affiliated securities lending agent received the remaining 40 percent, and that the amount received by the affiliated securities lending agent was disproportionate to the performance of the agent.

The plaintiffs seek relief under Section 36(b) of the Investment Company Act of 1940, which provides a right of action for excessive fund advisory compensation, as well as under Section 47(b), which provides a right of rescission for contracts made in violation of the 1940 Act, and Section 36(a), which authorizes the SEC to bring actions for breach of fiduciary duty.

The case serves as a good reminder that potential conflict of interest transactions need to be approached with great care. The SEC has made it clear that the board of directors (particularly the independent directors) need to be vigilant in overseeing the use of fund assets to ensure that fund shareholder are not harmed, especially when there is a potential conflict of interest with the fund’s investment adviser.

Enforcement Matters

CFTC Takes Enforcement Action Against Introducing Broker for Lying to the Regulator 

A recent enforcement action by the CFTC demonstrates the need for registrants to deal honestly with their regulators. On January 28, 2013, the U.S. District Court for the Southern District of Florida granted the CFTC’s request for summary judgment against Angus Jackson, Inc., a registered introducing broker that, according to the CFTC, lied to the CFTC about commission payments it made to a third party that had been barred from the commodity industry.

The court held that “concealing the true nature of commission payments to commodity trading advisors, regardless of whether those payments are lawful, is a serious matter that impedes the National Futures Association from performing its duties under the Commodity Exchange Act.”

Back in March 2012, the CFTC filed suit against Angus Jackson, Inc., its chief financial officer, and a client of the firm for covering up commission payments by the firm to the client, which was previously barred from the industry and could not legally receive such payments. According to the CFTC’s complaint, during audits conducted by the CFTC, the firm and its principal made false statements to the CFTC about the commission payments and took steps to conceal the true nature of those payments. The Court granted the CFTC’s request for summary judgment as well as a request for disgorgement plus prejudgment interest to be paid by the defendants. Finally, the Court granted the enforcement of civil penalties in an amount double the defendants’ monetary gains from the misconduct.

SEC Takes Enforcement Action Against Adviser for Inadequate Written Compliance Policies and Procedures

The SEC recently took enforcement action against a registered investment adviser (RIA) for failing to have written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 as required under Rule 206(4) of the Advisers Act (In the Matter of IMC Asset Management, Inc., Investment Advisers Act of 1940, Release No. 3537, January 29, 2013). The SEC also alleged that the RIA failed to conduct an annual assessment of its policies and procedures as required under Rule 206(4)-7.

According to the SEC’s complaint, the adviser failed during the period of more than three years to have written policies and procedures as required under the Advisers Act. Instead, the firm maintained written policies and procedures during this time addressing its predecessor’s business, that of being a securities broker-dealer. In addition, the firm employed a person during this same period to be its designated compliance officer, who performed no compliance-related functions, had no former compliance experience, and no formal training. In addition, the firm from the time it registered with the SEC in 2007 until the end of 2010 failed to conduct an annual review of its policies and procedures, as required under Rule 206(4)-7.

In order to resolve the matter with the SEC, the adviser agreed to: (i) require its current chief compliance officer to complete comprehensive training concerning the Advisers Act’s compliance requirements by December 31, 2013; (ii) retain the services of a compliance consultant to provide compliance services for the firm for a period of at least two years, and to implement all of the recommendations by the compliance consultant; and (iii) to certify to the SEC compliance with the undertakings described in (i) and (ii) above. The adviser further agreed to the SEC’s issuance of a cease and desist order, a censure of the firm, and the payment of a civil penalty of $30,000.

Financial Adviser Charged With Illegally Providing Insider Information

One of the hot topic areas of concern for the SEC is the use of material non-public trading information by professionals within the financial services industry. In this case against a Florida-based financial adviser, Kevin L. Dowd, the SEC alleges that, while Mr. Dowd did not personally trade on the material insider information, he did benefit monetarily by tipping the information to a person who traded on it.

According to the SEC, Mr. Dowd received details about an impeding acquisition of Pharmasset, Inc. in his capacity as a financial adviser for a registered broker-dealer. Mr. Dowd allegedly passed on the information to a friend in the penny stock promotion business, who traded on the information along with another person he “tipped,” resulting in profits in just two trading days of more than $700,000. Mr. Dowd, although he did not personally trade on the non-material information, did benefit by tipping the information though the receipt of a $35,000 payment and a jet ski dock from the tippee.

According to the SEC, as a financial advisor, Mr. Dowd should have known better and refrained from both tipping others and benefiting from such actions.

The SEC’s civil complaint was filed by the SEC in federal court in New Jersey and alleges that Mr. Dowd violated Sections 10(b) and (14)(e) of the Securities Exchange Act of 1934 and Rule 10b-5 and 14e-3 thereunder. The SEC is seeking disgorgement of Mr. Dowd’s ill-gotten gains, a financial penalty ,and permanent injunction against Mr. Dowd. In addition, the U.S. Attorney’s Office for the District of New Jersey, in a parallel action, announced criminal charges against Mr. Dowd.

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