A Compilation of Enforcement and Non-Enforcement Actions

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

Legal News: Investment Management Update

Non-Enforcement Matters

  • Investment Advisers — Are Your “IA Reps” Registered as Required? Why You Should Care 
  • Surviving the SEC Examination
  • SEC Announces Compliance Outreach Program
  • SEC Director of Investment Management Emphasizes Communication and Investor Protection
  • Oversight of Sub-Advisors

Enforcement Matters

  • Hedge Fund Adviser Charged With Overstating Valuations of Fund Assets

Non-Enforcement Matters

Investment Advisers — Are Your “IA Reps” Registered as Required? Why You Should Care

As we approach the end of the calendar year, it is a good time for investment advisers to check if all of its personnel who are providing services as an “investment adviser representative” (“IA Rep”) are registered where required under applicable state securities laws. This annual registration check-up is an important step in preventing and detecting violations of the IA Rep registration requirements. Such violations could lead to both regulatory enforcement actions against the adviser and the IA Rep and provide clients of the adviser serviced by the IA Rep with a private right of action under the applicable state securities law to recoup advisory fees paid during the period of the violation.

An “IA representative” is defined under Rule 203A-3(a)(1) under the Investment Advisers Act of 1940 as a “supervised person” (i.e., an employee, officer or director) of an investment adviser who:

  • Has more than 5 natural person clients (other than “excepted persons”); and
  • More than 10% of his or her clients are natural persons (other than “excepted persons”). The term “excepted person” means a natural person who is a “qualified client” as defined under Rule 205-3(d)(1) under the Advisers Act. A “qualified client” is defined as a natural person or company client who has at least $1 million under the management of the adviser or has a net worth (together, with the client’s spouse of assets held jointly) of more than $2 million (not including the client’s personal residence as an asset).

This definition of an IA Rep is applicable for supervised persons of a SEC registered IA. For advisers who are registered under state law, the definition of an IA Rep under the applicable state securities law is applied. Generally, most state laws define the term IA Rep in much the same way as under the Advisers Act, but there may be a wider net cast by the state law and state registered advisers should consult with the state securities law of each state in which it and its IA Reps have a place of business.

The state registration requirements for IA reps. of a registered IA generally consist of filing the Form U-4 for the individual electronically through the CRD system, depositing the appropriate registration fees, complying with the IA Rep examination requirements (generally the Series 65 or Series 66 and Series 7 exam) or qualify for a waiver of such examination by having a certain professional designation. Unless the individual applicant has an enforcement history, registration approval is general obtained within 10 to 15 days of filing the application. The applicant should not be acting as an IA Rep for the adviser in the state in which registration is applied at any time prior to obtaining registration by such state.

Generally, an IA Rep is not required to register in any state in which he or she does not have a place of business and has less than six clients in the state during the preceding 12 months.

If the adviser has supervised persons that may potentially provide services as an IA Rep within the near future in a state where registration is required, it is prudent to have those persons apply for registration ahead of time in order to avoid a delay of providing services to clients because the IA Rep was not timely registered to provide the services.

The penalties for noncompliance with the IA Rep registration requirements for both the IA Rep and the adviser can be severe. For example: (i) the state regulator may bring enforcement action (in the form of a fine, administrative order of prohibition or cease and desist, IA registration suspension, revocation or censure, denial of IA Rep registration, or a combination of all of the above). The implementation of enforcement actions by a state regulator would: (i) be required disclosure within the adviser’s publicly available Form ADV and on the IA Rep’s Form U-4; and (ii) provide a private right of action for clients serviced by the IA Rep while not registered which would provide for the return of advisory fees paid during such period, plus interest at the statutory rate and reimbursement of reasonable attorneys fees. Both the adviser and the IA Rep and the officers and directors of the adviser (unless they could show that they could not have reasonably known of the activities resulting in the violations) are jointly and severally liable with respect to each client’s private right of action.

Surviving the SEC Examination

As a compliance officer of or legal counsel to, an SEC registered investment adviser, it is likely that you have already experienced an SEC examination or will do so in the not-too-distant future. In order to survive the SEC examination, we offer the following tips:

  • Compliance Manual Readiness. The adviser’s compliance policies and procedures manual needs to be up-to-date and complete. Most importantly, determine whether the adviser is following its written policies and procedures and if not, find out why, and take appropriate action either to enforce the policies and procedures or revise the policies and procedures to more effectively prevent and detect violations. As a reminder, Rule 206(4)-7 under the Advisers Act requires the adviser to review its policies and procedures at least annually to determine their effectiveness and completeness. The compliance manual will be one of the first documents reviewed by the SEC examiners.
  • Select a Point Person. The adviser should designate the CCO or other officer of the adviser to be the point person for the SEC staff to make requests and to receive information. The designated person should have the confidence of management and the authority and expertise to respond to the SEC staff requests. All interviews of personnel requested by SEC staff should be conducted through the designated point person.
  • Employees Need to be Alerted. When informed about the SEC’s intended visit, it is necessary to alert all personal and instruct them to be cordial and cooperative. Personnel should be instructed to direct all staff requests to the adviser’s CCO or designated person.
  • Provide Appropriate Space for SEC Staff. The adviser should provide a dedicated office or other appropriate space for staff to examine records and to accommodate their confidential discussions. The staff appreciates the ability to have available facilities on site to conduct discreet discussions.
  • Request Updates from SEC Point Person. The SEC staff will have an examiner in charge to whom the adviser’s point person should be able to, at any time during the examination, discuss the progress of the examination, determine any material concerns of the staff, and the projected timetable for exam completion.
  • Meet Staff Concerns Head On. If the staff raises issues, the point person or the CCO should take immediate steps to address the issue. The staff will generally acknowledge remedial steps taken immediately to resolve an issue or concern raised during the examination. Outside counsel should be contacted to determine appropriate steps to be taken to help diffuse the issue, as necessary. The adviser’s personnel need to provide accurate and complete information to the staff. Any attempt to delay or provide incomplete or inaccurate information will be considered by the staff to be a reason for extending and/or broadening the scope of the examination and possibly to recommend enforcement action.
  • Be Responsive to Staff Requests. It will seem at times during the exam that the staff’s requests for items to review or questions to be answered are unending. However, it is important to provide timely and complete responses to all requests. The point person should field all such requests and questions. Maintaining a professional and cordial tone throughout the examination with the staff members may be considered by the staff when such personnel write up the results of the examination and make recommendations for further examination or action. 
  • Make Sure There is an Exit Interview. Generally, the staff will schedule a meeting just prior to leaving the adviser’s office to let the adviser’s CCO or point person know about any staff concerns relating to the examination findings. Oftentimes, the staff will have a list of items that the staff will later review during the post exam period. If the staff fails to schedule an exit interview, the CCO or point person should insist upon receiving one. There is no reason for the adviser to be left guessing about the outcome of the exam.

The best approach to surviving the SEC examination is to take the necessary steps ahead of time in preparation for such an exam. Hopefully, the tips provided above will assist the adviser in that preparation.

SEC Announces Compliance Outreach Program

The SEC’s Office of Compliance Inspections and Examinations (OCIE) and the Asset Management Unit of the SEC’s Division of Enforcement will conduct a compliance outreach program for chief compliance officers and other senior personnel of investment advisers and investment companies on January 30, 2014 at the offices of SEC’s headquarters in Washington, D.C. In person attendance is limited to 500 persons but others may view the webcast at www.sec.gov.

The agenda for the day-long program will include SEC priorities for 2014, private fund advisers, registered investment companies, the role of the chief compliance officer (CCO), and asset valuation issues. Investment adviser and investment company CCO’s will be given priority for in person attendance if the program exceeds its 500 in person cap. Interested persons can obtain additional information about the outreach program through ComplianceOutreach@sec.gov.

SEC Director of Investment Management Emphasizes Communication and Investor Protection

In remarks at the Independent Directors Council’s annual fall meeting, Director of the SEC’s Division of Investment Management, Norm, Champ, spoke on the importance of communication between mutual fund directors and the Division to enhance their shared mission of protecting investors. The Division communicates with directors through roundtables and meetings with the industry. The Division also maintains an outreach program to directors that began with the largest or most strategically important funds, but the SEC is extending this to other funds as well. To help directors stay aware of these items, the Chief Compliance Officer should regularly review the SEC’s regulatory materials and public communications, and report on them to the Board.

In this regard, it is clear, based on recent SEC comments, that the SEC remains focused on the duties of care and loyalty that mutual fund directors owe shareholders. The reason for this focus is that although these are state law precepts, they are precepts that are inextricably linked to federal responsibilities of mutual fund directors to mutual fund shareholders. Specifically, the Board is tasked with reviewing and addressing the conflicts inherent in a mutual fund’s structure. For example, this is the reason for the careful and detailed analysis by the Board each year that goes into renewing the investment advisory agreements.

Oversight of Sub-Advisors

Mutual funds are commonly managed by an adviser and a sub adviser. Generally, the adviser has overall responsibility for managing a fund, while the sub adviser is responsible for buying and selling securities for the fund. There can be a number of reasons for using this structure. For example, it may be a way for a fund complex to make available funds for which it lacks internal portfolio managers.

Regardless of the reasons for such a structure, the investment adviser remains responsible for overseeing the activities of the sub-adviser. It is important that this oversight be maintained to mitigate regulatory and litigation risk. Specifically, the investment adviser oversees the sub-advisers’ compliance with the investment sub-advisory agreement, adherence to a fund’s investment objective, investment strategy and investment restrictions, and compliance with regulatory requirements. Such oversight also includes the following:

  • Ongoing review and approval of sales and marketing materials used by the sub-adviser;
  • Periodic onsite visits to meet with senior executive personnel and portfolio management personnel;
  • Quarterly compliance monitoring; and
  • Annual compliance monitoring.

The board of directors also plays a key role in overseeing a sub-adviser. The board’s oversight generally focuses on questions relating to the quality of the sub-adviser’s investment performance, the effectiveness of the sub-adviser’s compliance program, and other specific areas, such as its code of ethics, affiliated transactions, any litigation, government investigations and examinations, and any changes in control.

Board oversight of a sub-adviser’s investment performance generally involves a review of the same types of information that the board considers in its review of the investment adviser’s performance. This usually requires reliance on the investment adviser to interact with the sub-adviser and provide the board with the necessary information, which may include the investment adviser’s own analysis of the sub-adviser’s performance.

With regard to a sub-adviser’s compliance program, a fund’s chief compliance officer (CCO) is responsible for administering the fund’s compliance program and for reporting to the board on the adequacy of the sub-adviser’s compliance program. The board should ask questions of the CCO to ensure that the CCO is fully versed in the sub-adviser’s compliance program and has done the necessary due diligence, including onsite visits.

Enforcement Matters

Hedge Fund Adviser Charged With Overstating Valuations of Fund Assets

On December 12, 2013, the SEC charged a UK-based hedge fund adviser, GLG Partners L.P. and its former U.S.-based holding company, GLG Partners Inc. for overvaluation of the assets of the fund it managed, GLG Emerging Markets Special Assets 1 Fund. The overvaluation of the assets caused the adviser to collect inflated fees for the management of such assets.

The SEC charged the adviser for failing to have proper controls in place to ensure that valuations and management fees are accurate. According to the SEC, the valuation violations occurred over a two-year period from 2008 to 2010 when the adviser’s internal controls caused the overvaluation of the fund’s 25 percent equity in an emerging company. An independent pricing committee was in place to determine the position’s monthly evaluation, but due to internal miscommunication, the relevant information for pricing was not shared with the persons who reviewed the evaluations.

The SEC’s final order in the matter cited violations by the adviser and its former holding company of certain provisions under the Securities Exchange Act of 1934 and rules thereunder. In order to settle the matter, the adviser and its former holding company agreed to the issuance of the SEC’s cease and desist order, establishment of a Fair Fund to distribute money to investors who were charged excessive fees, the payment of disgorgement of $7.7 million, interest of $437,679 and penalties of $750,000.

The SEC’s investigation of the matter came from the SEC’s Aberrational Performance Inquiry which uses proprietary risk analytics to identify hedge funds with suspicious returns.

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