A Compilation of Enforcement and Non-Enforcement Actions

29 August 2014 Publication
Authors: Peter D. Fetzer Terry D. Nelson Jason M. Hille

Legal News: Investment Management Update


  • SEC Proposes Extension of Principal Trade Rule for Registered Advisers/Broker-Dealers 
  • Use of Form PF Data Described by SEC
  • Persons Registered as Municipal Advisers Face SEC Examination Program
  • “Pay-to-Play” for Investment Advisers: The SEC’s First Prosecution
  • Improving Prospectus Disclosure
  • Alternative Investment Strategies


  • Another Conflict of Interest Enforcement Action Taken by the SEC Against a Registered Adviser


SEC Proposes Extension of Principal Trade Rule for Registered Advisers/Broker-Dealers

The SEC has proposed extending to December 31, 2016, the sunset date for the expiration of Rule 206(3)-3T (the “Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The Rule allows SEC-registered investment advisers who are also SEC-registered broker-dealers to sell securities on a principal basis to their clients without violating the “anti-fraud” provisions under the Advisers Act.

The Rule was first enacted under the Advisers Act by the SEC in 2007, and extended in each of 2009, 2010 and 2012. The Rule permits principal trading with clients by such registrants without having to obtain, in advance, the client’s consent to each transaction. An advance client consent is otherwise required under the rules of the Advisers Act. The SEC believes that, absent the Rule, such advisers would place their clients in a position where they would not be able to have full access to possible investment opportunities. Without the Rule, such advisers would also have to implement substantial policies and procedures in order to comply with the client consent per transaction requirement.

The SEC is now asking the public to comment generally on the proposed Rule extension and specifically to consider, among other things, whether the two-year extension is sufficient, whether the Rule should be extended at all, and, if not extended, what regulatory relief, if any, should be provided for advisers who are also registered as broker-dealers from the client consent requirement.

The consensus among SEC observers is that the public comment period will end with little opposition to the proposal to extend the Rule for another two-year period. The SEC is likely to extend the Rule as it currently provides but, in the meantime, continue with its ongoing “bigger-picture” review, as required under Section 913 of the Dodd-Frank Act, to conduct a study and provide a report to Congress concerning the obligations of broker-dealers and investment advisers. It is likely that the SEC’s subsequent report to Congress will include the application of the Rule and how it should fit within the overall regulatory scheme.

Use of Form PF Data Described by SEC

Registered investment advisers who manage private funds with at least $150 million in regulatory assets are required to file Form PF with the SEC on a periodic basis. Information obtained on the Form PF is designed to provide the SEC and the public a fair idea of the systematic risks taken on by the adviser through its management of the private funds. Private funds are those funds managed by the adviser that rely on certain exceptions to the definition of an investment company in order to avoid registration under that act. So what does the SEC do with the information it receives on the filed Form PFs?

As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC in its second annual report to Congress reported on its use of the data obtained from the filed Form PFs. The report describes the SEC’s Office of Compliance Inspections and Examinations’ (“OCIE”) use of the data in its examinations of the advisers who submit the filed report. The staff reportedly reviews the filed Form PFs before it goes on an examination of the private fund adviser, looking for inconsistencies among the filed Form PF, the adviser’s Form ADV and actual business practices. In addition, the SEC reports that its Enforcement Division Asset Management Unit uses the information collected on Form PFs to conduct its Aberrational Performance Inquiry (“API”). The API program provides the SEC the ability to identify private fund performance that is outside of the norm and becomes a focus of possible enforcement action. Already, the information collected from the API program has led to several recent enforcement actions against advisers who manage private funds.

Persons Registered as Municipal Advisers Face SEC Examination Program

The SEC recently announced that its Office of Compliance Inspections and Examinations (“OCIE”) will shortly commence an examination program of registered municipal advisers. The examination program will be phased in over the next few years. The focus of the examinations will be certain risk areas, including the municipal adviser’s compliance with its fiduciary duty to clients, maintenance of the required books and records and overall fair dealing with clients. Because the regulatory scheme for municipal advisers is new and most of the regulations governing same are still in the development phase, the OCIE staff will use the examination program, in part, to assist registrants on getting up-to-speed on the regulatory requirements.

Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act required those persons who are municipal advisers, unless exempt, to register as municipal advisers with the SEC and the Municipal Securities Rulemaking Board (“MSRB”). Registration phase in of municipal advisers commenced July 1 and is to be concluded by October 31, 2014.

The OCIE’s examination program will reportedly be conducted in phases; engagement of the registrants (currently taking place), the examination program, and informing registrants of SEC policy. An annual outreach program will be conducted by the SEC to provide registrants with an overview of best practices compliance programs to address the regulatory requirements for municipal advisers. It is expected that the Financial Industrial Regulatory Authority (FINRA) will examine those registered municipal advisers who are also registered broker-dealers and members of FINRA. The SEC will examine those municipal advisers that are not members of FINRA.

Part of the difficulty for newly registered municipal advisers is that many of them have not been part of an SEC examination program in the past and that the regulations have not been finalized and in some cases, not even in the proposal stage. The MSRB’s proposed Rule G-42 to establish core duties including the adviser’s fiduciary obligations to its clients, is currently out for public comment (ended August 25, 2014).

What will be necessary for the SEC while conducting its examination program is to provide patience with a largely new regulatory class that will not have a final set of regulations starting out.

“Pay-to-Play” for Investment Advisers: The SEC’s First Prosecution

On June 20, 2014, the Securities and Exchange Commission (“SEC”) brought and settled its first case under the “pay-to-play” rules for investment advisers. The SEC charged TL Ventures Inc. with violating the “pay-to-play” rules by continuing to receive advisory fees from the pension plans of the city of Philadelphia and state of Pennsylvania after a covered associate made campaign contributions to a candidate for mayor of Philadelphia and the governor of Pennsylvania. TL Ventures Inc. agreed to settle the charges by paying nearly $300,000 in disgorgement, prejudgment interest and civil money penalties. TL Ventures Inc. received illicit advisory fees from two public pension funds: (i) Pennsylvania’s state retirement system and (ii) Philadelphia’s pension plan, both, within two years of making the disqualifying contributions. The continuing relationship violated “pay-to-play” rules because the mayor of Philadelphia appoints three of the nine members of the Philadelphia Board of Pensions and Retirement. Similarly, the governor of Pennsylvania appoints six of the eleven-member board of Pennsylvania’s state retirement system. Thus, both the mayor and governor, who received campaign contributions from a covered associate of TL Ventures Inc., could influence the hiring of investment advisers for each pension plan.

On July 1, 2010, the SEC adopted Rule 206(4)-5 (the “Rule”), promulgated under Section 206(4) of the Investment Advisers Act of 1940. The Rule addresses “pay-to-play” violations involving campaign contributions made by advisers or their covered associates to government officials who have the ability to influence the selection of registered investment advisers who in turn manage government assets. The Rule does not require a showing of quid pro quo or actual intent to influence elected officials or candidates and prohibits an investment adviser from (i) providing advisory services for compensation to a government client for two years after the adviser or covered associate makes a contribution to certain elected officials or candidates who would have influence over an entity that hires the investment adviser; (ii) providing direct or indirect payments to any third party that solicits government entities for advisory services unless the third party itself is a registered broker-dealer or investment adviser subject to “pay-to-play” restrictions; and (iii) soliciting or coordinating contributions to political parties where the adviser is providing or seeking to provide advisory services to government entities controlled by the individual to whom the adviser directed the contribution.

As stated above, the Rule covers contributions made by either the investment adviser or any covered associate. Under the Rule, covered associates are deemed to be officers and employees of the adviser who have a direct economic stake in the adviser’s relationship with the government client. Covered associates are defined to include, among others: (i) any general partner, managing member or executive officer; (ii) any employee who solicits a government entity for the investment adviser; and (iii) any political action committee controlled by the investment adviser or by any of its covered associates. Furthermore, executive officers include: (i) the president; (ii) any vice president in charge of a principal business unit, division or function; (iii) any other officer of the investment adviser who performs a policy-making function; or (iv) any other person who performs similar policy-making functions for the investment adviser. 

Improving Prospectus Disclosure

The staff of the SEC’s Division of Investment Management issued guidance urging mutual funds to be more succinct, avoid technical language and use plain English in the Summary Section of fund prospectuses.

In its guidance, the staff observed that, although disclosure by funds is often clear and concise, a significant number of Summary Sections remain “complex, technical, and duplicative.” Some are also quite long, reaching 10 or 20 pages instead of the intended three to four pages. The staff said that the information on principal investment strategies and risks in the Summary Section does need to be an actual summary of key information and not a mere repetition of detailed information available elsewhere.

The SEC highlighted the following disclosure items: 

  • Summarize the Principal Investment Strategies and Risks: Form N-1A provides that the principal investment strategies and risks, required by Item 4 in the Summary Section, should be based on the information given in response to Item 9 of the Form, and should be a summary of that information. Instead of a concise summary, however, the staff often observes in Item 4 of the Summary Section long, complex and detailed descriptions of principal investment strategies and risks that are dense, are not user-friendly, and do not appear to be summaries of the information in Item 9 later in the prospectus. 
  • Plain English Requirements: Form N-1A provides that the Summary Section must be provided in plain English under Rule 421(d) under the Securities Act. In addition, the prospectus, in its entirety, is subject to the requirement that the information be presented in a clear, concise, and understandable manner. Notwithstanding these requirements, the staff continues to observe the use of technical terms that are not explained in plain English. Funds also often use unnecessary defined terms, long, compound sentences, and long, dense paragraphs that the staff believes might be difficult for investors to read. 
  • Summary Section Must Only Include Required or Permitted Information: Form N-1A provides that the Summary Section of the prospectus “may not include disclosure other than that required or permitted by [Items 2 through 8].” A fund may, however, include information elsewhere in the prospectus or in the Statement of Additional Information (SAI) that is not otherwise required by Form N-1A. The staff closely scrutinizes the disclosure in the Summary Section, and when information is included that is not required or permitted, comments that the information should be moved out of the Summary Section. 
  • Inclusion of Non-Principal Strategies and Risks in the Prospectus: As noted above, Form N-1A requires a fund to disclose its principal investment strategies and risks in its prospectus. The Form provides that a fund should describe any investment strategies and risks that are not principal in the SAI. Form N-1A, however, also provides that a fund may include (except in the Summary Section) information in the prospectus that is not otherwise required. Many funds include in their prospectus additional information related to strategies and risks that are not principal. In the view of the staff, however, funds that include this additional information often do not clearly indicate which of the strategies and risks are principal and which are not principal. 
  • Avoid Cross-References: Form N-1A provides that, in responding to the required information in the prospectus, funds should avoid cross-references to the SAI or shareholder reports. The Form further provides that “[c]ross references within the prospectus are most useful when their use assists investors in understanding the information presented and does not add complexity to the prospectus.” The staff frequently observes funds with numerous cross-references in the Summary Section, which the staff believes can add complexity that should be avoided.

At the next annual update, Funds should review their prospectus disclosure to determine if any enhancements are advisable with regard to this guidance.

Alternative Investment Strategies

Funds that use alternative investment strategies should be aware of the SEC focus on their use in mutual funds and should evaluate their policies and procedures regarding, among other things, asset segregation and liquidity determination. Additional information regarding SEC statements on alternative investment strategies is found below.

Even for funds that do not use alternative investment strategies, the SEC’s sweep examination regarding alternative investments has revealed that the SEC is very focused on the quality of board minutes and ensuring that the board minutes report key determinations related to compliance with the Investment Company Act. So, all funds should evaluate the quality of their minutes.

In a public address, SEC Investment Management Director Norm Champ spoke about the growing use of alternative investment strategies employed by open-end mutual funds. He talked about the potential benefits and the risks associated with these funds and related developments at the SEC. Champ emphasized the importance of monitoring and managing the risks that arise in connection with alternative mutual funds.

Champ suggested that alternative mutual fund managers consider a number of issues in connection with the development of robust valuation policies and procedures, including the requirement to monitor for circumstances that might necessitate the use of fair value prices. He noted that managers also might wish to address the methodology by which the fund determines fair value, the process for price overrides, and assurance that controls are in place to review, monitor, and approve all overrides in a timely manner. In addition, he stated that the policies and procedures also should address the prompt notification to, and review and approval by, persons not directly involved in portfolio management to mitigate any conflicts of interest.

In the area of liquidity, Champ said that significant holdings of securities that are fair-valued by alternative mutual funds might raise concerns about the liquidity of the holdings, including the process for testing and monitoring liquidity to comply with the Investment Company Act liquidity limitation. The staff believes that funds should consider setting criteria for assessing the liquidity of a security and consider including the criteria in written policies and procedures for registered fund compliance programs.


Another Conflict of Interest Enforcement Action Taken by the SEC Against a Registered Adviser

The president of a registered investment advisory firm, Jason D. Huntley, agreed to, among other things, a five-year bar from association with any investment adviser, broker, dealer, municipal securities dealer or transfer agent, for violations of the “anti-fraud” provisions under the Investment Advisers Act of 1940.

The violations cited by the SEC against Huntley were in the form of failing to disclose certain conflicts of interest to clients as the president of an advisory firm registered under the Advisers Act. On one such occasion, Huntley failed to inform investors in his managed private fund that fund assets were being used to provide loans to one or more of his related entities. On another occasion, Huntley failed to inform his clients that he would receive a finder’s fee in connection with introducing the adviser of another fund to representatives of a publicly traded special purpose acquisition company. Although Huntley asked the investors to provide written consent to the transaction, as required, he omitted the fact that he would personally gain from the transaction through the receipt of a finder’s fee for arranging the transaction.

In order to settle the SEC enforcement action, Huntley, without admitting or denying the charges, agreed to the five-year bar, the issuance of a cease-and-desist order, the prohibition of serving or acting as an employee, officer or director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or for an affiliated person of any of such entities, and pay a civil penalty of $100,000. 

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

Jason M. Hille
Milwaukee, Wisconsin