A Compilation of Enforcement and Non-Enforcement Actions

30 April 2014 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Enforcement Matters

  • Improper Calculation of Client Advisory Fees Results in Enforcement Action

Non-Enforcement Matters

  • Cybersecurity Is a Top Concern
  • Private Funds to Be Subject of New SEC Dedicated Examination Unit
  • SEC Issues Guidance on Social Media and the Testimonial Rule
  • Mutual Fund May Not Exclude Socially Responsible Shareholder Proposal From Its Proxy Statement

Enforcement Matters

Improper Calculation of Client Advisory Fees Results in Enforcement Action

In a recent action (In the Matter of Transamerica Financial Advisors, Inc., Investment Advisers Act Release No. 3808/April 3, 2014), a St. Petersburg, Florida-based, registered investment adviser and broker-dealer agreed to SEC sanctions for improperly calculating advisory fees and overcharging clients. According to the SEC, the firm has already reimbursed more than 2,300 current and former clients with refunds and credits of about $553,624. The firm agreed to pay a penalty in that same amount.

The firm offered breakpoint discounts in fees for clients who participated in certain investment programs offered by the firm. However, the firm failed to provide the discounted rates to certain clients although they qualified for the reduced fee. According to the SEC, the improper calculations and overcharging commenced in 2009 and was the subject of the SEC’s concerns during a routine examination of the firm in 2010. Although the firm took steps to refund certain clients subsequent to the SEC’s 2010 examination, it failed to make recalculations and provide refunds on a firm-wide basis. During a subsequent examination of the firm by the SEC in 2012, it was discovered that the firm continued to overcharge fees for certain client accounts.
The firm was cited by the SEC for violations of the “anti-fraud” provisions as well as a failure to have implemented adequate written policies and procedures as required under the Investment Advisers Act of 1940 to prevent and detect such prohibited activities.

The firm, while neither admitting nor denying the SEC’s charges, agreed to the penalty payment, the issuance of the SEC’s cease and desist order, and to retain an independent consultant to review its policies and procedures particularly with respect to the firm’s fee schedules and fee computation methods.


Non-Enforcement Matters

Cybersecurity Is a Top Concern

Cybersecurity has become a top concern of the customer service sector as well as regulators of securities broker-dealers and investor advisers. The SEC recently announced that it would be examining 50 registered broker-dealers and investment advisers to test for cybersecurity preparedness.

Since the Target Corp. security breach earlier this year, both the securities industry and its regulators have taken a more proactive approach in order to better understand the vulnerability of the industry and how the industry is addressing those vulnerabilities. The Financial Industry Regulatory Authority (FINRA) commenced a similar effort earlier this year when it asked member firms to respond to questionnaires addressing their cybersecurity preparedness initiatives.

According to a recent report from the Federal Bureau of Investigation and Department of Homeland Security, about 3,000 companies experienced security system breaches in 2013.

The 50 registered broker-dealer and investment advisers to be examined by the SEC for cybersecurity preparedness also received a request for information and documents designed, in part, to assist registrants in their compliance efforts.

Experts in the cybersecurity area have stated recently that the securities industry is extremely vulnerable to cybersecurity attacks and that attempts by the industry to address such vulnerabilities are probably, for the most part, ineffective. According to such experts, the industry will need to come up with new technology security programs that can more effectively respond to cyber threats and to report more immediately when a breach occurs.

The SEC suggests that firms employ a “risk-based approach” to the cybersecurity threat instead of relying upon ineffective approaches applied previously. Cyber hackers are looking for personal information about customers of broker-dealers and investment advisers. The SEC will conduct the exams of the 50 registrants to determine how accessible that information is to hackers and what can and should be done to thwart those hackers from obtaining customer personal information.

For those registrants who are not examined, it is believed that once the SEC makes public the results of the examinations and release of “best practices,” the entire industry should benefit.


Private Funds to Be Subject of New SEC Dedicated Examination Unit

The SEC recently announced that it has formed a new examination unit dedicated to the examination of private equity and hedge funds. The unit will be headed by industry veterans, Igor Rozenblit and Marc Wyatt, and will examine hedge fund and private equity firms for, among other things, asset valuation, reports to investors, and organizational structures.

The hiring of persons from the industry such as Messrs. Rozenblit and Wyatt, indicates a new approach by the SEC. The SEC apparently believes that it takes industry hands-on experience to best understand how the industry operates. Mr. Rozenblit was in the industry until 2010 when he joined the SEC. Since then, he has served as a specialist in private equity funds. Mr. Wyatt has been with the SEC since 2012, serving as a specialist in hedge funds after heading a registered investment adviser hedge fund operation in London.

Since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, private funds such as private equity and hedge funds have been the subject of intense regulatory scrutiny. Since 2010, the investment adviser registration requirements and exempt private fund adviser reporting requirements have resulted in about 500 new registered investment advisers. The initial round of SEC examinations of some of these newly registered investment advisers has reportedly uncovered significant regulatory concerns.

The SEC, in forming the new unit dedicated to examination and compliance issues of such firms, headed by two persons with hands-on industry experience, is expected to assist the SEC with more effective regulation over such firms.


SEC Issues Guidance on Social Media and the Testimonial Rule

Investment advisers may not use testimonials in their advertisements (the “testimonial rule”). In general, a testimonial is a statement of a client’s experience with, or endorsement of, an investment adviser. The application of the testimonial rule in the era of social media has not always been clear, but now the SEC has issued guidance that should be helpful to investment advisers.

The guidance makes it clear that an investment adviser may not publish public commentary that is an explicit or implicit statement of a client’s experience with or endorsement of the investment adviser on the investment adviser’s Internet or social media site. On the other hand, the guidance provides that the following are permissible:

  • An investment adviser may publish on its Internet or social media site public commentary that comes from an independent social media site, subject to the following conditions: 
    • The investment adviser may not have any ability to suppress the publication of all or a portion of the commentary, edit the commentary, or organize or prioritize the order in which the commentary is presented. 
    • The investment adviser may not draft or submit commentary that is included on the third-party social media site. This means that the investment adviser may not directly or indirectly author the commentary regardless of whether it is done in its own name, a third-party’s name, or an alias, assumed, or screen name. 
    • The independent social media site must allow for the viewing of all public commentary regarding the investment adviser, and the investment adviser must publish all of the unedited comments appearing on the third-party social media site. 
    • There may not be any material connection between the independent social media site and the investment adviser that would call into question the independence of the third-party social media site. This means, for example, that the investment adviser may not compensate a social media user for authoring commentary. 
  • An investment adviser may include investment adviser advertisements on an independent social media site, even if the investment adviser publishes public commentary from such site, subject to the following conditions: 
    • It must be readily apparent to the reader that the investment adviser’s advertisement is separate from the public commentary featured on the third-party social media site. 
    • The receipt or non-receipt of advertising revenue may not in any way influence which public commentary is included or excluded from such third-party social media site. 
  • In newspaper, radio and television advertisements, an investment adviser may reference the fact that public commentary regarding the investment adviser may be found on an independent social media site.

Mutual Fund May Not Exclude Socially Responsible Shareholder Proposal From Its Proxy Statement

A recent SEC no-action letter is a reminder that even though mutual funds do not hold regular shareholder meetings, mutual funds may find themselves subject to shareholder proposals when they are required to hold a special shareholder meeting. The no-action letter also demonstrates that it may be difficult to exclude shareholder proposals related to the adoption of socially responsible investment procedures.

While the mutual fund received the shareholder proposal in 2010, it still had to address the inclusion of the proposal when the fund was required to hold a special shareholder meeting in 2014. The shareholder proposal was worded as follows: “RESOLVED: Shareholders request that the Board institute transparent procedures to prevent holding investments in companies that, in management's judgment, substantially contribute to genocide or crimes against humanity, the most egregious violations of human rights.”

The mutual fund moved to exclude the shareholder proposal pursuant to Rule 14a-8(i)(5), which allows a proposal to be excluded if it relates to operations that account for less than five percent of the fund’s total assets at the end of its most recent fiscal year, and for less than five percent of its net earnings and gross sales for its most recent fiscal year, and is not otherwise significantly related to the fund’s business. The fund demonstrated that it met the objective tests of this exclusion, and then moved to demonstrate that it met the subjective test, namely that the shareholder proposal was not significantly related to the fund’s business.

The mutual fund argued that since it was a money market fund investing in municipal securities, not in equity securities, and only in U.S. dollar-denominated securities, the shareholder proposal was not significantly related to the fund’s business because the proposal appears to relate to equity investments in foreign companies. While there seems to be merit to this argument, the SEC did not find it persuasive and said it was unable to concur in the view that the shareholder proposal could be excluded.


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
608.258.4215
tnelson@foley.com

Peter D. Fetzer
Milwaukee, Wisconsin
414.297.5596
pfetzer@foley.com

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