A Compilation of Enforcement and Non-Enforcement Actions

29 May 2015 Publication
Author(s): Peter D. Fetzer Stuart E. Fross Terry D. Nelson

Legal News: Investment Management Update


  • Compliance Issues With Private Equity Fund Managers Remains a Concern With the SEC
  • SEC Issues Guidance on Cybersecurity for Funds and Advisers
  • Whistleblowing Compliance Officer Awarded More Than $1 Million by SEC
  • Acting Director Grim Named Director of SEC Division of Investment Manager
  • Funds That Are First-Time Filers of Form BE-10: Now Due June 30
  • SEC Proposes Rules to Modify Reporting Regime for Registered Investment Companies and Investment Advisers


  • Failure by a Registered Investment Adviser to Correct Examination Deficiencies Leads to SEC Enforcement Action
  • SEC Enforcement Action on Adviser Profitability Analysis


Compliance Issues With Private Equity Fund Managers Remains a Concern With the SEC

In May of last year, the SEC rang the alarm bells after conducting sweep examinations of private equity fund managers. At that time, the SEC noted that the results of the sweep exams indicated significant and wide spread violations by equity fund managers of the “anti-fraud” provisions under the Investment Advisers Act of 1940.

The sweep examinations that started in October 2012 by the SEC’s Office of Compliance, Inspections and Examinations (“OCIE”) and covered more than 150 private equity fund managers, focused on among other things, the managers’ allocation of expenses, calculation of fees, and valuation of assets.

In a recent presentation to the Private Equity International Conference, Marc Wyatt, the OCIE’s Acting Director, provided the audience with the SEC’s current thinking about the state of compliance by private equity fund managers. The good news according to Acting Director Wyatt is that the SEC sees an uptick in increased compliance efforts while the not-so-good news is that there is still substantial room for improvement.
According to Acting Director Wyatt, the industry appears to be evolving into more transparency as to fees, and expenses. In addition, the staff has witnessed closer adherence to the provisions of formation documents and disclosure about the rights of the private equity fund investors. Some managers are engaging outside consultants to provide feedback on their fee practices and to ensure that all fees are properly and fully disclosed within the fund offering documents.

An area of concern that has seen some improvement (but not enough) by private equity managers is that the brunt of expenses are absorbed by the main fund instead of being shared by parallel funds. According to the SEC, disclosure does not cure this lack of fairness as the fiduciary obligations of the manager to the fund investors requires fair and impartial treatment of all parties who are being managed by the manager. In addition, the allocation of investments among the main fund and the parallel funds has not only been an area of inadequate disclosure but oftentimes lacks a written policy to be followed by the manager and fully disclosed to the investors.

According to Acting Director Wyatt, a common concern regarding private equity real estate manager is the amount of fees being charged and questionable claims that the fees are “of market.” The staff notes that oftentimes such managers are claiming “market-rate” fees when there has been no data collected by the managers to determine the market rate.

Approximately 25% of the registered private equity fund managers were examined during the OCIE’s presence examinations. It is likely that these managers will be subject to, in the near future, a full exam by the OCIE. In that exam, the staff will expect improvement in the areas of most concern as uncovered in the presence exams. In addition, the OCIE will especially be reviewing those private equity vehicles designed especially for “retail” type investors to determine if enhanced transparency and disclosure is present.

SEC Issues Guidance on Cybersecurity for Funds and Advisers

The SEC has identified the cybersecurity of registered investment companies (“funds”) and registered investment advisers (“advisers”) as an important issue. As such, the SEC has issued guidance highlighting the importance of the issue and discussing a number of measures that funds and advisers may wish to consider when addressing cybersecurity risks.

Key Take Away: The SEC recognizes that is it not possible for a fund or adviser to anticipate and prevent every cyber attack. However, the SEC believes appropriate planning to address cybersecurity and a rapid response capability may assist funds and advisers in mitigating the impact of any such attacks and any related effects on fund investors and advisory clients. Accordingly, the fund’s board should carefully review and consider the measures referenced in the SEC’s guidance.

Summary: In the SEC’s view, there are a number of measures that funds and advisers may wish to consider in addressing cybersecurity risk, including the following (the suggested measures are not intended to be comprehensive and other measures may be better suited depending on the operations of a particular fund or adviser):

  • Conduct a periodic assessment of: (1) the nature, sensitivity and location of information that the firm collects, processes and/or stores, and the technology systems it uses; (2) internal and external cybersecurity threats to and vulnerabilities of the firm’s information and technology systems; (3) security controls and processes currently in place; (4) the impact should the information or technology systems become compromised; and (5) the effectiveness of the governance structure for the management of cybersecurity risk.
  • Create a strategy that is designed to prevent, detect and respond to cybersecurity threats. Such a strategy could include: (1) controlling access to various systems and data via management of user credentials, authentication and authorization methods, firewalls and/or perimeter defenses, tiered access to sensitive information and network resources, network segregation, and system hardening (see definition of system hardening below); (2) data encryption; (3) protecting against the loss or exfiltration of sensitive data by restricting the use of removable storage media and deploying software that monitors technology systems for unauthorized intrusions, the loss or exfiltration of sensitive data, or other unusual events; (4) data backup and retrieval; and (5) the development of an incident response plan.
  • "System hardening" refers to making technology systems less susceptible to unauthorized intrusions by removing all non-essential software programs and services, unnecessary usernames and logins and by ensuring that software is updated continuously.
  • Implement the strategy through written policies and procedures and training that provide guidance to officers and employees concerning applicable threats and measures to prevent, detect and respond to such threats, and that monitor compliance with cybersecurity policies and procedures.
  • Adopt compliance policies and procedures that are reasonably designed to prevent violations of the federal securities laws. For example, the compliance program of a fund or an adviser could address cybersecurity risk as it relates to identity theft and data protection, fraud, and business continuity, as well as other disruptions in service that could affect, for instance, a fund’s ability to process shareholder transactions.
  • Implement a mechanism to monitor for ongoing and new cyber threats by gathering information from outside resources, such as vendors, third-party contractors specializing in cybersecurity and technical standards, and topic-specific publications and conferences, as well as participating in the Financial Services —Information Sharing and Analysis Center (FS-ISAC).
  • Assess whether protective cybersecurity measures are in place at relevant service providers.
  • Review contracts with service providers to determine whether they sufficiently address technology issues and related responsibilities in the case of a cyber attack.


Whistleblowing Compliance Officer Awarded More Than $1 Million by SEC

The SEC recently announced that a compliance professional has been awarded $1.4 to $1.6 million for reporting misconduct inside his firm to the SEC. The previous award to a compliance officer whistleblower was $300,000. In both instances, the compliance officer made a report to management, concluded that no appropriate action was taken, and then took the matter up with the SEC. In addition, the SEC has vigorously responded in connection with a retaliation case – awarding $600,00 to a whistleblower victim of employer retaliation.

Key Take Away: A compliance program that effectively results in prompt action being taken to address wrongdoing or missteps is the best protection. The fund’s board should continue to interface with the fund’s chief compliance officer on a regular basis to ensure the compliance officer believes management is responsive to compliance personnel and compliance issues that are brought to management’s attention, and that management fully supports the compliance department.

Summary: The award related to the compliance officer involved a compliance officer who had a reasonable basis to believe that disclosure to the SEC was necessary to prevent imminent misconduct from causing substantial financial harm to the company or investors. When investors or the market could suffer substantial financial harm, the SEC rules permit compliance officers to receive an award for reporting misconduct to the SEC. The compliance officer in questions reported misconduct after responsible management at the entity became aware of potentially impending harm to investors and failed to take steps to prevent it.

The whistleblower award for retaliation stemmed from a June 2014 enforcement action with $2.2 million in fines. In the matter of Paradigm Capital Management, the SEC found that a hedge fund portfolio manager caused a hedge fund to trade with a broker-dealer (acting as principal) that was under common control with the hedge fund, by virtue of the fact that the portfolio manager was a control person of both the fund and the broker-dealer, absent the requisite client disclosure and consent mandated by Section 206(3) of the Investment Advisers Act. The SEC also found the adviser’s Form ADV to be misleading, for failure to disclose the improper principal transactions. The then head trader of the adviser who placed the inappropriate trades on the portfolio manager’s instructions reported the adviser’s misconduct to the SEC and then informed his employer of his whistleblowing, setting in motion a series of retaliatory actions by the employer. The SEC found that the employer’s retaliation violated Section 21(F) of the Securities Exchange Act, which prohibits any form of discrimination against a whistleblower, as well as Sections 206(3) of the Investment Advisers Act (principal trades without valid client consent) and Section 207 of the Investment Advisers Act (misleading Form ADV disclosure).

By way of reminder, the SEC operates an Office of the Whistleblower. Under the SEC’s whistleblower policies, compliance and internal audit professionals are seen to be on the front lines of addressing compliance matters, but can and (evidently) do become whistleblowers if management’s response proves inadequate.

Officers and directors of firms that have engaged in misconduct are generally not considered eligible for whistleblower awards. However, if a corporate officer (such as the head trader) or director reports information to the SEC 120 days after other responsible officers (particularly compliance officers) fail to take appropriate action, then the SEC is prepared to reward officer/director whistleblowers. By law, the SEC must protect the confidentiality of whistleblowers and cannot disclose any information that might directly or indirectly reveal a whistleblower’s identity.

Acting Director Grim Named Director of SEC Division of Investment Manager

The Securities and Exchange Commission recently announced that David Grim has been named as Director of the Division of Investment Management. Mr. Grim has served as the division’s acting director since February, taking over the reins from former director Norm Champ following his January departure to become a legal scholar at Harvard Law School.

“David is a committed public servant with a nearly 20-year tenure in the Division of Investment Management,” said SEC Chair Mary Jo White. “I am confident that the Commission and the public will continue to benefit from his leadership and deep knowledge of the work of the division on behalf of investors.”

Mr. Grim joined the SEC in September 1995 as a Staff Attorney in the division’s Office of Investment Company Regulation. In January 1998, he moved to the division's Office of Chief Counsel and was named Assistant Chief Counsel in September 2007. Mr. Grim was appointed as Deputy Director of the division in January 2013, with responsibility for overseeing all aspects of its disclosure review, rulemaking, guidance, and risk monitoring functions.

Mr. Grim will have oversight for many significant projects in the division’s future, such as the SEC’s plans to propose a uniform fiduciary standard for investment advisers and broker-dealers across all products, as well as a series of more current initiatives including modernizing the data that fund companies report to the commission to cover their use of derivatives, the liquidity and valuation of their holdings and their securities lending practices.

“It is an honor to serve America’s investors as the Director of the Division of Investment Management,” said Mr. Grim. “I look forward to working with Chair White, the Commissioners, and the staff in my new role as we carry out the Commission’s remarkable mission.”

Mr. Grim graduated cum laude with a degree in political science from Duke University and received his law degree from George Washington University, where he was Managing Editor of the George Washington Journal of International Law and Economics.

Historically, our experience has been that Mr. Grim has advocated within the Division in favor of the staff granting no-action relief and industry guidance. We believe that the industry has cause for hope that he will set this tone from the top.

Funds That Are First-Time Filers of Form BE-10: Now Due June 30

Fund managers of master feeder funds, money managers investing in foreign companies, or firms with foreign affiliates, should take note of Form BE-10, a new filing obligation with an approaching deadline.

The Bureau of Economic Analysis of the U.S. Department of Commerce (“BEA”) announced that the filing deadline for all new filers has been extended to June 30, 2015. A new filer refers to a U.S. company or person that is required to file on the BE-10 survey but has never filed any BEA survey of U.S. direct investment abroad, including the BE-10, BE-11 and BE-577 surveys. Previously, the deadline for filers required to file fewer than 50 forms was May 29, 2015, and June 30, 2015 for those filers required to file 50 or more forms.

The BEA conducts the BE-10 benchmark survey of U.S. direct investment abroad every five years to gather current economic data on the operations of U.S. parent companies and their foreign affiliates, including private funds. The information reported on the Form BE-10 includes the products and services provided by, the number of employees of, and the revenue and other financial data of, a U.S. reporter and its non-U.S. affiliates.

A BE-10 report is required of any U.S. person that had a foreign affiliate - that is, that had direct or indirect ownership or control of at least 10 percent of the voting stock of an incorporated foreign business enterprise, or an equivalent interest in an unincorporated foreign business enterprise, including a branch – at any time during the U.S. person’s 2014 fiscal year. A U.S. person refers to any individual, branch, partnership, associated group, association, estate, trust, corporation or other organization (whether or not organized under the laws of any state) and any government (including a foreign government, the U.S. Government, a state or local government, and any agency, corporation, financial institution, or other entity or instrumentality thereof, including a government-sponsored agency).

If a U.S. private fund parent had at least 10 percent voting interest in a foreign business enterprise, including a fund, it must report regardless of whether it had any equity (financial) interest in the foreign fund. An investment manager may be a U.S. parent if it meets these criteria. If a private fund is a limited partnership, BEA considers ownership of voting interest in limited partnerships to be divided equally among the general partners, with the limited partners owning no voting interest, unless otherwise specified in the ownership or partnership agreement.

There remains some ambiguity regarding U.S. persons with no foreign affiliates. Although the instructions on the BEA’s website indicate that all U.S. persons with no foreign affiliates must make a BE-10 Claim for Not Filing, the BEA’s training video makes plain that if the U.S. person had no foreign affiliates during its 2014 fiscal year and if it was notified by the BEA that a filing is required, then the U.S. person must file a “BE-10 Claim for Not Filing”, and that otherwise no filings are required.

SEC Proposes Rules to Modify Reporting Regime for Registered Investment Companies and Investment Advisers

On May 20, 2015, the Securities Exchange Commission (the “SEC”) approved a set of proposals relating to registered investment companies and investment advisers to modernize and enhance information reporting. Among other things, the proposals require data to be provided in a structured data format which will allow the SEC to more efficiently aggregate and analyze the data to monitor industry trends, inform policy and rulemaking, identify risks and assist the SEC’s staff in examination and enforcement efforts.

Investment Adviser Act Rulemakings

The SEC has proposed a number of revisions to Form ADV to fill data gaps, enhance reporting requirements, designed to capture information on advisers to separately managed accounts akin to that now captured on Form PF for private fund advisers. The SEC also took the opportunity to rationalize the way in which private fund managers operating with multiple general partner entities will be able to register their” relying advisers” under an umbrella registration approach. The SEC is also proposing record keeping rule changes, designed to capture the basis for performance advertisements sent to individuals, in part to close what appears to be a loophole that precluded the Staff from successfully prosecuting an investment adviser in the context of potentially misleading performance advertising. In addition, the SEC proposes numerous technical and clean up amendments to Form ADV and to certain Dodd-Frank related transitional rules.

ADV Amendments. In particular, the Form ADV changes would require an adviser to provide certain aggregate information on the separately managed accounts it advises, including information on regulatory assets under management, investments and use of derivatives and borrowings. Advisers would update this information annually, although larger advisers ($10 billion in “separately managed account regulatory assets under management”) would annually supply annual and semi-annual data. The proposed new Form ADV will require an adviser to disclose other information concerning its advisory business including the use of social media and information relating to branch office operations. Advisers to separately managed accounts would also have to identify the custodians that hold 10% or more of their clients’ separately managed account RAUM and the amount of assets that those custodians hold. The enhanced reporting is designed to improve the quality and depth of the information the SEC collects from investment advisers and to facilitate its risk monitoring initiatives.

Umbrella Registration. The SEC has also proposed amendments to Form ADV that will establish a more efficient and more easily navigable method for the registration of multiple private fund adviser entities operating a single advisory business on one Form ADV. These amendments follow recent no-action guidance to advisers from the SEC Staff, make availability of umbrella registration more widely known to advisers, regularize the registration process for umbrella filers and provide more consistent data about, and create a clearer picture of, groups of advisers that operate as a single business as well as allowing for greater comparability across private fund advisers. It is noteworthy that this relief is limited – effectively – to private fund advisers, and is not proposed to be extended to all registered investment advisers.

Performance Advertising Recordkeeping. In addition to the proposed revisions to Form ADV, the SEC has proposed revisions to Rule 204-2, which would require advisers to make and maintain originals of supporting documentation demonstrating performance calculations or rates of return in any written communications that the adviser circulates or distributes, directly or indirectly, to any person, including those related to the performance or rate of return of any or all managed accounts or securities recommendations. Such revisions are intended to better protect investors from fraudulent performance claims.

Investment Company Act Rulemakings

Many of the SEC’s proposed series of rules, forms and amendments are intended to increase the transparency of fund portfolios and investment practices, modernize information reporting and disclosure by taking advantage of technological advances and, where appropriate, reduce duplicative or otherwise unnecessary reporting burdens, such as by providing funds with an optional method under new Rule 30e-3 to satisfy shareholder report transmission requirements by posting such reports online if they meet certain conditions.

The investment company proposals include the introduction of new Form N-Port, which would replace Form N-Q and would require monthly reporting of a fund’s portfolio-wide and position level holdings including additional information relating to derivative instruments and certain risk metric calculations intended to measure a fund’s exposure and sensitivity to changing market conditions. Although funds would be required to file Form N-Port on a monthly basis, only information contained on Form N-Port for the last month of the fund’s last fiscal quarter would be made available to the public following a 60-day delay.

In addition, the SEC has proposed amendments to Regulation S-X that would require standardized enhanced disclosures concerning the fund’s investments in derivatives as well as other disclosures related to liquidity and pricing of investments, including securities on loan. The SEC’s proposed rules conform to the disclosures required by both Regulation S-X and Form N-Port to eliminate inconsistent disclosures across funds’ financial statements thereby facilitating greater comparability and analysis of derivatives instruments industry-wide.

The SEC also proposed new Form CEN to replace Form N-SAR. Form CEN will include many of the same census data elements but would replace those that are outdated or of little usefulness with those the SEC believes to be of greater relevance today. In addition, Form CEN will be filed in a structured data format to allow for more effective data aggregation and analysis and will be filed on an annual basis rather than semi-annually to further reduce burden on funds.

Comment Period

The comment period for the proposals will be 60 days after publication in the Federal Register, or July 19, 2015.


Failure by a Registered Investment Adviser to Correct Examination Deficiencies Leads to SEC Enforcement Action

It is imperative for a registered investment adviser upon being notified by the SEC during an examination that is has deficiencies, to work to resolve those deficiencies before the next SEC examination. In the Matter of Trust & Investment Advisors, Inc., Larry K. Pitts, and George M. Prugh, IAA Release No. 4087/May 18, 2015, a SEC registered investment adviser based in Indiana and its two principal officers, were the target of a recent SEC enforcement order and sanctions for failure to cure deficiencies noted during previous SEC examinations.

During three on-site examinations at the adviser in 2005, 2007 and 2011, the SEC discovered and alerted the adviser to deficiencies in the areas of performance, advertising and compliance. For example, during the 2005 examination, the SEC pointed out to the adviser that it had failed to develop compliance procedures as required under Rule 206(4)-7 under the Investment Advisers Act of 1940. In a written response to the SEC, the adviser stated that it was working on those compliance procedures. However, again during the 2007 examination, the SEC noted that the procedures were still not completed and noted other obvious compliance deficiencies. Subsequently, the adviser once again stated to the SEC, that it would complete those procedures and eliminate the other compliance deficiencies. In spite of all that, during the 2011 examination (6 years from the time the compliance procedures deficiency was first noted), the SEC discovered that the adviser had made no progress on the compliance deficiencies.

During the series of exams conducted by the SEC on the adviser over the six year period, it was also noted by the staff that the adviser provided misleading performance information in its marketing materials. As in the case of the compliance deficiencies, although the adviser made repeated written statements to the SEC that it would correct the deficiencies, the SEC found in 2011 that the adviser had not eliminated the deficiencies. The two principals of the adviser cited in the enforcement action were the supervisory and decision makers at the adviser. Accordingly, the SEC believed that the adviser’s continued failure was the direct result of the failure of the two principals to ensure that the deficiencies were satisfactorily resolved. In order to settle the SEC’s enforcement action, the adviser and the principals have resolved to take certain action to resolve the areas of deficiencies, including the completion by each of the two principals of thirty (30) hours of compliance training. The matter was resolved through the SEC’s cease and desist order, order of censure and a payment of a civil penalty by each of the respondents.

SEC Enforcement Action on Adviser Profitability Analysis

The SEC recently instituted and settled an enforcement action against an investment adviser to a family of mutual funds for improperly calculating the fund adviser’s profitability in connection with annual renewals of its advisory contract. The SEC found that the adviser violated Section 15(c) of the Investment Company Act of 1940. The adviser and its CFO/CCO were subjected to a cease-and-desist order and required to pay civil money penalties of $50,000 and $25,000, respectively.

Section 15(c) makes it unlawful for registered funds to enter into or renew any advisory contract unless the terms of the contract are approved by a majority of the funds’ independent directors. While Section 15(c) does not define what is “reasonably necessary” to evaluate a contract’s terms, the SEC has promulgated various fund filing disclosure requirements to better inform shareholders about a board’s evaluation process when approving or renewing an advisory contract.

As to the approval or renewal of an advisory contract, funds must include a discussion in their shareholder reports concerning, among other things, the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the funds.

Key Take Away: A key part of the process of renewing funds’ advisory contracts under Section 15(c) is assessing the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the funds. In turn, it is important that fund boards understand the expense allocation methodology that an adviser uses in calculating its profitability, including the methodology for allocating employee compensation expenses to the funds. The board should ensure that it is comfortable with the adviser’s profitability analysis and the methodology for allocating expenses to the fund.

Summary: The funds’ board considered the renewal of the advisory contracts on an annual basis. As part of the process, the board requested certain information from the adviser for the board’s consideration, including an analysis of the profitability of each fund to the adviser over the past two years, including expenses related to services provided to each fund, with an explanation of the expense allocation methodology. In response, the adviser provided the board with a one-page analysis of its profitability in managing the funds for its latest two fiscal years.

The profitability analysis included line items for, among other things: total revenue; total operating expenses; net operating income before income taxes; and net income before income taxes. The bulk of the expenses were employee compensation, of which the compensation of the chief executive officer (CEO) made up a significant portion. The adviser represented that employee compensation was allocated based on estimated labor hours, although it also stated that the CEO’s compensation allocation was an estimate based on his time and his intangible value to the funds.

Contrary to what the adviser had stated in its profitability analyses furnished to the board, the adviser did not allocate the CEO’s compensation to the funds based solely upon the CEO’s estimated labor hours and intangible value to the funds. In actuality, the adviser adjusted the allocation of the CEO’s compensation in a manner designed, in part, to achieve consistency of the reported profitability in managing the fund year over year. From 2010 to 2012 the percentage of the CEO’s compensation allocated to the funds increased from 35% to 49.5%, and the increases kept the adviser’s reported pre-tax net profit margin in a narrow range of 26.8% to 28.1%. In 2013 the CEO's compensation increased by more than 70% and, in part in order to avoid showing a significant reduction in profitability, the adviser allocated just 25% of the CEO’s compensation to managing the funds, resulting in a reported pre-tax net profit margin of approximately 40%.

The SEC concluded, in part, that the adviser’s methodology for allocating employee compensation expenses to the funds was reasonably necessary for the board to evaluate the terms and renewal of the advisory contracts, and failure to accurately provide this information was a violation of Section 15(c) by the adviser.

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

Stuart E. Fross
Boston, Massachusetts

Jonathan S. Lipnick
Boston, Massachusetts