A Compilation of Enforcement and Non-Enforcement Actions

28 March 2013 Publication
Author(s): Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters

  • Recent Newsworthy Remarks by the SEC 
  • SEC Issues “Alert” on the Custody Rule 
  • Securities Exchange Act Issues for Exchange-Traded Funds 
  • Mutual Funds’ After-Tax Returns Adjusted for Tax on Net Investment Income

Enforcement Matters 

  • Hedge Fund Managers Subject to SEC Fraud Charges

Non-Enforcement Matters

Recent Newsworthy Remarks by the SEC

During recent public appearances, spokespersons for the SEC’s Division of Investment Management’s Risk and Examinations Group (REG) provided additional insight as to what the REG will be looking for when it conducts examinations of registered investment advisers.

According to Norm Champ, SEC Director of the Division of Investment Management, REG will have two roles; one is to conduct “rigorous quantitative and qualitative financial analysis of the asset management industry” and second (but not last) to work closely with the SEC’s Office of Compliance Inspections and Examinations (OCIE) to come up with its examination program and also to assist OCIE in conducting its examinations. According to Director Champ, the REG will especially work on learning more about the issues faced by the investment management industry and help promote best practices within the industry. The Director added that OCIE and REG leadership has been meeting with the boards of asset management firms and has been hiring experts in and from the industry in an attempt to better understand and regulate the industry.

In another appearance, Director Champ stated that the Division’s review of private fund advisers will emphasize advertising and Form ADV by such advisers. According to the Director , the rapid increase in registration of investment advisers brought on by the Dodd-Frank Wall Street Reform and Consumer Protection Act and the exemption filing by private fund advisers could, out of necessity, require the SEC to recommend revisions to Form ADV and certain rule changes. Given the expected change under Rule 506(c) under Regulation D — which will allow the general solicitation and general advertising for issuers, including private funds that sell their securities solely to accredited investors — the Director believes that it may be necessary for the SEC to rethink its position on various advertising prohibitions now in place for advisers of private funds. Finally, according to Director Champ, given the complexity of how some of the private fund advisers are structured, with multiple related-parties that may be providing advice, all under one organizational umbrella, Form ADV reporting and even registration for such related entities may have to be modified.

Meanwhile, Andrew Bowden, the Division’s Deputy Director, informed the public that about one in 10 examinations conducted by OCIE results in a referral for SEC enforcement action. According to Mr. Bowden, OCIE would like to see that number decrease as an enforcement referral means additional staff time and expense. OCIE hopes to ward off some of the enforcement referrals by educating the industry as to best practices and necessary steps to avoid enforcement action. According to Mr. Bowden, SEC considerations when determining whether to seek enforcement action include:

  • Is there an ongoing fraud? 
  • Has the target(s) attempted to hide the fraud? 
  • Is there egregious harm to investors? 
  • Is this conduct a repeated violation by the same target(s)? 
  • Would the target(s) pay back the victims for losses absent an enforcement referral?

Generally, if an adviser finds itself dealing with the SEC in a matter that may be referred, it is important to take immediate action to correct the behavior that caused the violation, as well as cooperate with, and do not mislead, the SEC during its investigation.

SEC Issues “Alert” on the Custody Rule

On March 4, 2013, the SEC released a risk alert in connection with Rule 206(4)-2, also known as the “Custody Rule,” issued under the Investment Advisers Act of 1940. Several of the issues outlined by the SEC specifically target advisers to pooled investment vehicles, such as advisers to private equity or hedge funds. The SEC identified other issues applicable to all investment advisers, in addition to those advising pooled investment vehicles.


The SEC implemented the Custody Rule as a way to provide additional safeguards to investors against theft or misappropriation when investment advisers have “custody” of client funds or securities. An investment adviser has custody of client funds or securities when the adviser (1) holds client funds directly or indirectly; or (2) has authority to obtain possession of such funds or securities, such as having a power of attorney from the client to sign checks on the client’s behalf. Additionally, having the ability to dispose of client assets also constitutes custody for purposes of the Custody Rule.


An investment adviser with custody of client assets must maintain client funds and securities with a qualified custodian, such as a bank, registered broker-dealer, futures commission merchant, or certain foreign entities, and must provide certain information to the client, such as the name and address of the custodian. The investment adviser must then have reasonable certainty that the custodian is sending regular account statements to the client, which can be used by the clients to verify the information received from the adviser about the assets within the adviser’s custody. Further, the investment adviser must enter into an agreement with an independent accounting firm to perform a surprise annual audit. Finally, where the client is a pooled investment vehicle, such as a limited partnership or limited liability company, the adviser must ensure that the account statements required to be sent to the client are also provided to the limited partners or members of the pooled investment vehicle.

Risks Discovered by the SEC

Advisers to pooled investment vehicles often rely on the “audit approach” to comply with the Custody Rule. However, this approach often results in the following deficiencies under the Custody Rule by advisers:

  1. The auditor was not independent within the meaning of Regulation S-X or registered with the PCAOB and subject to PCAOB inspection 
  2. The audited financials are not prepared in accordance with the Generally Accepted Accounting Principles 
  3. The adviser could not demonstrate that all audited financials were distributed to ALL investors in the fund, or that such financials were sent to investors within 120 days following the close of the fund’s fiscal year
  4. No final audit was performed at liquidation of the pooled investment vehicle


Failure by Advisers to Recognize They Have Custody

  1. The SEC identified the following situations in which advisers often fail to recognize that they have custody of client funds or assets within the meaning of the Custody Rule:
  2. The adviser personnel or a related person serve as the trustee, or have been granted a power of attorney for client accounts 
  3. The adviser engages in bill-paying services in connection with the client 
  4. The adviser performs its management services by using the client’s personal account user names and passwords to access accounts holding the client’s assets 
  5. The adviser acts as the general partner, or other similar position such as a manager of an LLC, of a pooled investment vehicle 
  6. The adviser has physical possession of the client’s security certificates or other assets 
  7. The adviser has check-writing authority over a client’s account or otherwise receives checks issued to the client and fails to promptly return such checks to sender


Advisers also were failing to meet the surprise exam requirements by failing to file Form ADV-E within 120 days of the exam being performed. In addition, the SEC has found that the exam was not being performed on a surprise basis.

In addition to the above problems, the SEC also found that the advisers were found not in compliance with the “qualified custodian” requirements of the Custody Rule. For instance, some advisers failed to have their position as custodian or trustee for the client clearly notated on the account. Others commingled property of clients, employees, and the adviser itself in one account. Still others did not have a basis to believe that the qualified custodian was sending account statements to clients.


Advisers should periodically review their internal controls and processes to make sure that they are in compliance with their obligations under the Advisers Act, including the Custody Rule.

Advisers would be well advised to contact their legal and accounting representative for assistance with any such review.

Securities Exchange Act Issues For Exchange-Traded Funds

Since shares of exchange traded funds (ETF Shares) are continuously offered and are also traded in secondary markets, various issues arise under the Securities Exchange Act of 1934. Issues also arise under the Securities Exchange Act because most ETF Shares are purchased and redeemed in-kind. We have noted some confusion over some obligations under the Securities Exchange Act for ETF Shares, particularly with regard to Section 13 and Section 16 compliance. What follows is a brief summary of issues under the Securities Exchange Act that are applicable to ETF Shares. It does not provide comprehensive advice or identify each rule, regulation, document or action that an exchange traded fund (ETF) should consider in addressing issues under the Securities Exchange Act.

Available No-Action Relief

The SEC has granted no-action relief to ETFs with respect to compliance with Section 13(d) and Section 16 of the Securities Exchange Act, and has indicated that ETFs no longer need to submit requests for no-action relief unless novel or unusual issues are present. See Select Sector SPDR Trust, No-Action Letter (publicly available May 6, 1999), and PDR Services Corporation, No-Action Letter (publicly available December 14, 1998).

The SEC has issued generic no-action relief that obviates the need for index ETFs to obtain their own no-action relief for items related to Regulation M, tender offers, broker confirmations, margin, disclosure of broker relationships, and advance notice of corporate actions, as discussed below. See The American Stock Exchange, No-Action Letter (publicly available August 17, 2001). In addition, the SEC has consistently granted equivalent no-action relief to ETFs that are not tied to an index, and has indicated that such ETFs no longer need to submit requests for no-action relief with respect to broker confirmations, margin, and disclosure of broker relationships unless novel or unusual issues are present. See WisdomTree Trust, No-Action Letter (publicly available May 9, 2008).

Specific Securities Exchange Act Issues

Sections 13(d) and 16(a). Section 13(d) requires beneficial owners of more than five percent of an issuer’s outstanding securities to file reports with the SEC. Section 16(a) requires each officer, director, and beneficial owner of more than 10 percent of a public company’s outstanding shares (insiders) to file reports with the SEC disclosing the number of shares beneficially owned, and reports regarding changes in ownership. The SEC has granted no-action relief to ETFs with respect to the reporting obligations under Sections 13(d) and 16(a) to the effect that: (1) owners of more than five percent of the ETF Shares are not required to file reports under Section 13(d); and (2) insiders are not required to file reports under Section 16(a).

The no-action relief with respect to sections 13(d) and 16(a) is based primarily on representations that the ETF Shares trade at prices that do not deviate materially from NAV. The letters caution, in this regard, that if the ETFs Shares begin to trade at prices that materially deviate from NAV, the no-action relief would no longer be available.

Regulation M. Regulation M is intended to limit the activities of those persons who have a readily identifiable incentive to manipulate the market during an offering. Regulation M exempts from its application redeemable securities issued by an open-end management investment company, and an ETF is an open-end management investment company. However, because of the limited redeemability of ETF Shares, it is not clear that the exemption for open-end investment companies is applicable to ETFs. As a result, ETFs have sought, and the SEC has been willing to grant, no-action positions confirming that: 

  • Persons who may be deemed to be participating in a distribution of ETF Shares may bid for or purchase such ETF Shares during their participation in such distribution 
  • The receipt of securities comprising the basket of securities received in connection with the redemption of ETF Shares does not constitute an “attempt to induce any person to bid for or purchase a covered security, during the applicable restricted period” within the meaning of Regulation M 
  • ETFs may redeem ETF Shares during the continuous offering of such ETF Shares.

Tender Offers. Rule 14e-5, among other things, prohibits a person who makes a cash tender offer or exchange offer for an equity security from purchasing, directly or indirectly, such security other than pursuant to the offer. Rule 14e-5 could be read as restricting the ability of a dealer manager of a tender offer for a particular security included in the ETF’s portfolio from purchasing and redeeming ETF Shares during the offer period. That would be the case to the extent that purchases and redemptions of ETF Shares are viewed as an indirect purchase or sale of the security subject to the tender offer. To obviate concerns in this regard, ETFs have sought, and the SEC has been willing to grant, exemptive relief from Rule 14e-5 to permit dealer-managers of tender offers of securities comprising the basket of securities tendered or received in connection with a purchase or redemption of ETF Shares to purchase and redeem ETF Shares during the pendency of the offer.

Broker Confirmations. Rule 10b-10 requires a broker-dealer who effects a transaction on behalf of a customer to provide the customer a written confirmation at or before completion of the transaction. The confirmation must contain certain specified information, including the identity, price, and number of shares or units (or principal amount) of the security purchased or sold.

Compliance with Rule 10b-10 would be extremely burdensome to the extent that all of its requirements were viewed as applicable to all securities comprising the basket of securities tendered or received in connection with a purchase or redemption of ETF Shares. For this reason, ETFs have sought, and the SEC has been willing to grant, exemptive relief to permit broker-dealers to omit information respecting the identity, price and number of shares of each individual security tendered or received. The SEC has been willing to grant such relief conditioned upon the representation that the confirmation furnished by the broker-dealer to its customer will state that all information required by Rule 10b-10 will be furnished upon request and all such requests will be fulfilled in a timely manner.

Margin. Pursuant to Section 11(d)(1) of the Securities Exchange Act, a broker-dealer generally may not extend credit in connection with the purchase of any security that is part of a new issue if the broker-dealer was a member of the selling syndicate within the prior 30 days. Because ETFs are continuously offered as well as traded in the secondary market, the restrictions on margin in connection with purchases in a public offering could be viewed as applicable to ETFs. To obviate this concern, ETFs have sought and obtained no-action relief from the SEC to permit margin credit to be extended, in connection with the purchase of ETF Shares on an exchange, by broker-dealers who engage exclusively in secondary market transactions in ETF Shares. The SEC has also extended this relief to broker-dealers who transact directly with the ETF. In both cases, the relief is subject to the condition that the broker-dealer not receive, from the ETF or an affiliated person of the ETF, any payment, compensation, or other economic incentive to promote the shares of the ETF.

ETFs have also received confirmation that ETF Shares may be treated by broker-dealers as shares issued by an open-end investment company and therefore, pursuant to Rule 11d1-2 of the Securities Exchange Act, broker-dealers are able to extend credit or maintain or arrange for the extension or maintenance of credit on ETF Shares that have been owned for more than 30 days by the persons to whom credit is to be provided.

Disclosure of Broker Relationships. A broker-dealer is required, under Rule 15c1-5 under the Securities Exchange Act, to disclose to its customers any control relationship between the broker-dealer and the issuer of the security being purchased or sold. Similarly, a broker-dealer that effects a transaction with a customer in connection with any distribution in which the broker-dealer is interested, is required, under Rule 15c1-16 under the Securities Exchange Act, to disclose to its customer the existence of such interest. ETFs have obtained no-action relief from the SEC to confirm that the foregoing rules do not require disclosure of a broker-dealer’s relationship with any issuer of a security held in the ETF’s portfolio.

Advance Notice of Corporate Actions. Rule 10b-17 requires a public company to give advance notice of certain specified actions (for example, dividends, stock splits, rights offerings). Paragraph (c) of the Rule, however, states that the Rule does not apply to redeemable securities issued by open-end investment companies. However, because of the limited redeemability of ETF Shares, it is not clear that the exemption for open-end investment companies is applicable. As a result, ETFs have sought, and the SEC has been willing to grant, no-action positions confirming that this exemption applies to ETFs.

 Mutual Funds’ After-Tax Returns Adjusted for Tax on Net Investment Income

The SEC staff has announced that reported after-tax returns for mutual funds and exchange-traded funds must be adjusted to reflect the 3.8% tax on net investment income that became applicable to some taxpayers on January 1, 2013. This affects fund advertising as well as required disclosures in the fund prospectus. The announcement was made on the SEC’s web page for Investment Management Staff Issues of Interest. The full staff announcement reads:

“After-Tax Return Effective January 1, 2013, the Health Care and Education Reconciliation Act of 2010 (Pub. L. No. 111-152, 124 Stat. 1029 (2010)) imposed on certain taxpayers a 3.8% tax on net investment income (‘3.8% tax’).

“The staff recently was asked for its views on whether the 3.8% tax should be included in determining the highest individual marginal federal income tax rate used to calculate after-tax return required by Instructions 4 to both Item 26(b)(2) and (3) of Form N-1A. Since investors that are subject to the highest marginal rate on taxable income (currently 39.6%) are also subject to the 3.8% tax, we believe that registrants should include the 3.8% tax in after-tax return calculations (e.g., use 43.4% as the highest individual marginal federal income tax rate on ordinary income). Similarly, we believe that registrants should include the 3.8% tax in calculating the tax on qualified dividend income and long-term capital gains or any tax benefit resulting from capital losses required by Instruction 7 to Item 26(b)(3) (i.e., use 23.8% as the highest individual federal long-term capital gains tax rate, which is the sum of the 3.8% tax and the 20% maximum long-term capital gains tax rate).” [February 22, 2013]

Enforcement Matters

Hedge Fund Managers Subject to SEC Fraud Charges

Recently, the SEC filed a complaint in federal court in Connecticut charging a pair of hedge fund managers (Messrs. David Bryson and Bart Gutekunst) and their investment advisory firm (New Stream Capital) with lying to the hedge fund’s investors about the fund’s financial condition and other related matters before it failed during the 2008 financial crisis.

According to the SEC’s compliant, New Stream provided investment management services through Messrs. Bryson and Gutekunst to a $750 million hedge fund. In order to appease its largest investor, the hedge fund adviser agreed to give that investor preferential liquidation rights over those of all other fund investors. New Stream was afraid that the large investor would pull its investment out of the fund (estimated to be $300 million of the $750 million total assets of the fund) if it did not agree to the preferential treatment. What New Stream failed to do is inform the other fund investors that it granted the preferential terms to the one investor and the implications to them. In spite of the lack of disclosure, New Stream continued to solicit new investors in the fund. In addition, the fund’s financial statements were falsified to omit the preferential treatment restructuring for the major investor.

Due to the financial crisis in 2008, the fund faced substantial redemptions (in the amount of $545 million) and eventually filed for bankruptcy in 2011. The SEC’s complaint charges the fund managers, along with New Stream’s CFO, who falsified the fund’s audited financial statements, with violations of the “anti-fraud” provisions under federal securities laws, including under the Investment Advisers Act of 1940. The SEC is seeking a variety of sanctions and relief against the defendants, including injunctions, disgorgement of ill-gotten gains with interest, and penalties.

In a parallel action, the U.S. attorney is pursuing criminal charges against the individual defendants.

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