A Compilation of Enforcement and Non-Enforcement Actions

08 November 2013 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters

  • SEC Focused on Compliance Programs
  • SEC Beefing Up its Risk and Examinations Office
  • SEC Guidance on Valuation of Portfolio Securities
  • Affiliated Exchange-Traded Funds May Merge

Enforcement Matters

  • Violations of Custody Rule by Advisers Result in SEC Enforcement Actions

Non-Enforcement Matters

SEC Focused on Compliance Programs

The Securities and Exchange Commission (SEC) continues to be very focused on compliance programs, and is bringing more enforcement actions to drive home the importance of maintaining a good compliance program. This means the relationship between a board of directors and the fund’s chief compliance officer is of utmost importance.

This focus on the importance of compliance programs is clearly seen in the recent SEC enforcement action in which the SEC proceeded against a former portfolio manager who allegedly misled his firm’s chief compliance officer and falsified documents to hide his failure to report personal securities trades. It was the SEC’s first case under Rule 38a-1(c) of the Investment Company Act, which makes it unlawful for investment fund employees to mislead or otherwise manipulate a firm’s chief compliance officer.

The enforcement action is important because it held the portfolio manager directly accountable, not only for his substantive violations, but also for obstructing the chief compliance officer’s work. This is a clear signal that the SEC believes compliance programs are vital, and that the chief compliance officers tasked with monitoring and maintaining such programs must be given the resources and support necessary to ensure adherence with such compliance programs.

So, boards of directors should ensure that they communicate regularly with the chief compliance officer to ensure sufficient resources and support are being provided to the compliance program. If boards and chief compliance officers work together closely to ensure that the compliance program is carried out in a diligent fashion and in good faith, then they should have little need to fear an SEC enforcement action.

SEC Beefing Up its Risk and Examinations Office

The Securities and Exchange Commission (SEC) is working to improve its Risk and Examinations Office (REO). The REO exists to help provide the SEC with quantitative risk analysis capabilities as it monitors investment companies.

As the SEC has noted in the past, it looks to be collaborative with investment companies by providing guidance and alerts on risks confronting them, and an improved REO could help investment companies become aware of potential risks facing funds sooner than they would otherwise. In turn, this could put investment companies in a position to take proactive steps to avoid issues that might arise.

However, it appears that one trade off of “beefing up” the REO may be that the SEC will require additional disclosures of investment companies. For example, the SEC has on the one hand pointed to Form N-MFP, which money market mutual funds use to report their monthly portfolio holdings, as having been “extremely valuable” in enabling the SEC to monitor trends, identify outliers, and inform its rule-writing efforts. On the other hand, the SEC has referred to the “hodgepodge of data collection and reporting forms with outdated technology” for other types of investment companies, including closed-end funds and exchange-traded funds, and stated that it is looking at developing reporting for funds other than money market funds that could give the SEC timely and accurate information about their operations and portfolio holdings.

SEC Guidance on Valuation of Portfolio Securities

The Securities and Exchange Commission (SEC) has signaled that it may issue guidance regarding the valuation of portfolio securities by investment companies. It is expected that the SEC would reaffirm what remains applicable in its existing guidance on valuation of portfolio securities, modify what should be modified in such guidance, and supplement that with new guidance on topics that were not previously addressed, such as the use of pricing services for valuation, fund use of derivatives, and investments in foreign currencies.

There is no indication that such guidance is imminent, but it is a focus of the SEC. In light of recent enforcement actions involving portfolio valuation issues, current, updated SEC guidance on valuation of portfolio securities would be welcomed, as boards of directors continue to grapple with valuation issues.

Affiliated Exchange-Traded Funds May Merge

The Securities and Exchange Commission (SEC) continues to focus on issues related to exchange-traded funds (ETFs), as the market for ETFs continues to grow. For example, the SEC has again hinted that it may adopt rules to facilitate the creation of ETFs, and the SEC has recently provided guidance that makes it clear that affiliated ETFs may merge under Rule 17a-8 of the Investment Company Act.
Investment companies should note that the guidance on ETF mergers is limited, as it applies only to affiliated ETFs and requires strict adherence to Rule 17a-8, which subjects such reorganizations to disclosure, registration and shareholder-approval requirements designed to protect shareholders. Indeed the SEC warns in the guidance that it may take a different view regarding other types of ETF reorganizations, mentioning as an example a traditional open-end investment company merging, or converting, into an ETF.

Nonetheless, the SEC guidance does settle an area of ambiguity around ETF reorganizations, as the exemptive orders on which ETFs rely to operate do not contemplate a merger of affiliated ETFs. So, without this guidance it was unclear if affiliated ETFs could merge.

With this guidance now in place, mergers of affiliated ETFs that are effected in compliance with Rule 17a-8 may proceed, even though an ETF’s exemptive order does not contemplate a merger of affiliated funds.

Enforcement Matters

Violations of Custody Rule by Advisers Result in SEC Enforcement Actions

On October 28, 2013, the SEC announced sanctions against three SEC registered investment advisers for violations of the “custody rule” (Rule 206(4)-2) under the Investment Advisers Act of 1940 (Advisers Act).

The three advisers Further Lane Asset Management, LLC headquartered in New York, New York, GW & Wade, LLC, located in Wellesley, Massachusetts, and Knelman Asset Management Group, LLC, located in Minneapolis, Minnesota have all settled with the SEC’s enforcement actions without admitting or denying the SEC’s findings.

The SEC’s findings in these actions are good examples of what the SEC looks for in terms of compliance with the custody rule during its examinations and the consequences of non-compliance.

In the case of Further Lane Asset Management, LLC (“FLAM”), the violation of the custody rule was the failure of FLAM, while maintaining custody of hedge fund assets it managed, to arrange for an annual surprise audit to verify the fund’s assets and to ensure that the fund’s investors received account statements at least on a quarterly basis from the fund’s qualified custodian. The violations by FLAM of the custody rule were coupled with violations by FLAM of the requirement to maintain written policies and procedures designed to prevent violations of the Advisers Act and for engaging in securities transactions with advisory clients on a principal basis without providing the required written disclosure to, or obtaining consent from, such clients. Back in 2003, the SEC cited FLAM in a deficiency letter based on findings during an SEC examination that FLAM failed to comply with the custody rule and failed to obtain client’s consent while conducting principal transactions with clients.

All of the SEC cited violations with respect to FLAM are violations of the “anti-fraud” provisions under Section 206 of the Advisers Act. FLAM agreed to sanctions including a cease and desist order, a censure, payment of a civil penalty of $150,000 and disgorgement payment with interest of $356,000, and to continue to engage an outside consultant in implementing internal policies and procedures designed to prevent similar violations in the future.

Knelman Asset Management Group (KAMG) and its chief compliance officer (CCO) were found by the SEC to have violated the custody rule by failing to arrange for the annual surprise examination of a private fund’s assets and having those assets maintained by a qualified custodian. KAMG was also cited for failure to have adequate policies and procedures and failure to maintain various books and records, all as required under the Advisers Act. KAMG agreed to designate a new person as its CCO, and have that person complete compliance training, to the issuance of order of censure, and pay a civil penalty of $60,000. In addition, the firm’s outgoing CCO was barred from acting as a CCO for three years and ordered to pay a penalty in the amount of $75,000.

The third firm cited by the SEC, GW & Wade, LLC (GW&W), was found to have violated the custody rule as it used pre-executed letters of authorization for transferring client assets without obtaining the client’s execution prior to the use of such authorization. In addition, the firm failed to identify itself as a “custodian” of client assets on its Form ADV. According to the SEC, due to the use of this authorization by the adviser and without adequate safeguards in place, an unauthorized person was able to wire client funds to a foreign bank. Further, GW&W was cited for overbilling certain client accounts. The adviser was censured and ordered to cease and desist and required to pay a civil penalty of $250,000. In addition, the firm agreed to reimburse all clients for excess fees charged by the adviser.

According to Andrew Ceresney, co-director of the SEC’s Division of Enforcement, these disciplinary matters are examples of where registered firms failed to comply with the custody rule requirements and that the SEC will “vigorously enforce such requirements.”

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