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March 2016 - Compilation of SEC Enforcement and Non-Enforcement Actions

Non-Enforcement

Remember to Update Your Risk Disclosure on an Ongoing Basis

The staff of the Securities and Exchange Commission (SEC) issued guidance reminding mutual funds, exchange traded funds, and other registered investment companies of the importance of reviewing their risk disclosures on an ongoing basis and considering whether these disclosures remain adequate in light of current market conditions.

Key Takeaways: The following are key considerations for investment companies:

  • Monitor market conditions and their impact on fund risks on an ongoing basis and assess the impact of changing conditions on the fund and the risks associated with its investments. Funds should routinely engage in this practice as a normal part of day-to-day operations.

  • Assess whether fund risks have been adequately communicated to investors in light of current market conditions. If a fund determines that changed market conditions have affected the risks associated with the fund, the fund should assess the significance of the change and whether it is material to investors. If it is material, a fund should consider whether its existing disclosures are adequate in light of the changed conditions.

  • A fund that determines that changes in current market conditions have resulted in changes to the fund’s risks that are material to investors, and that its current disclosures do not adequately communicate the changes, should update its communications to investors. Means of communication to be considered include the prospectus (which, for example, would be updated when the fund determines that the risk disclosure in its prospectus would be materially misleading) and shareholder reports, as well as less formal methods, such as website disclosure and letters to shareholders.

  • A fund that exposes investors to market, credit, or other risks, and whose name suggests safety or protection from loss, should reevaluate the name, as appropriate, to eliminate the potential for investor misunderstanding.

  • A fund that uses investment strategies that employ derivatives should disclose material risks relating to volatility, leverage, liquidity, and counterparty creditworthiness associated with the fund’s trading and investments in derivatives. This disclosure should be tailored to the specific derivative instruments in which a fund invests or will invest principally.

  • A fund’s adviser should consider providing information to the fund board on the steps taken by the adviser to evaluate fund risk disclosures and consider whether changes are appropriate to respond to changing market conditions or other developments.

Summary: Clear and accurate disclosure of the risks of investing in funds is important to informed investment decisions and, therefore, to investor protection. A mutual fund, for example, is required to summarize the principal risks of investing in the fund, including the risks to which the fund’s portfolio as a whole is subject and the circumstances reasonably likely to affect adversely the fund’s net asset value, yield, and total return, in both its summary prospectus and statutory prospectus.

The guidance is intended to address another important aspect of fund risk disclosure, namely, the changes in a fund’s susceptibility to risk that may result from changes in market conditions and the need for funds to review and assess risk disclosures in light of changing market conditions. Degree of risk is dynamic in nature rather than static; it changes in response to market conditions, and different risks may be heightened or lessened at different points in time. As a result, a fund may determine that risk disclosure that may have been adequate at one time may need to be reconsidered in light of new or changed market conditions.

If a fund determines that its risk disclosure is not adequate, the SEC believes that the fund should consider the appropriate manner of communicating changed risks to existing and potential investors, for example, in the prospectus, shareholder reports, fund website, and/or marketing materials.

SEC Guidance on Payments to Financial Intermediaries

The SEC released guidance from the staff of the Division of Investment Management on issues that may arise when mutual funds make payments to financial intermediaries that provide shareholder and recordkeeping services for investors whose shares are held in omnibus and networked accounts maintained with mutual funds. In particular, the guidance addresses whether a portion of those payments are being used to finance distribution and therefore, if paid by a fund, must be paid pursuant to Rule 12b-1 under the Investment Company Act of 1940. The guidance characterizes these payments as “sub-accounting fees,” although it notes that they may also be characterized as sub-transfer agent, administrative, and other shareholder servicing fees.

Key Takeaways: The following are key considerations for the board of directors of a mutual fund:

  • Funds should ensure they have policies and procedures reasonably designed to prevent violations of Section 12(b) of the Investment Company Act and Rule 12b-1 regardless of whether they have Rule 12b-1 plans.

  • When the recipient of payments for services also finances distribution (for example, an intermediary that distributes fund shares), it raises a question as to the direct or indirect use of fund assets, requiring relevant input from the investment adviser and other relevant service providers and the informed judgment of the board.

  • The board should have a process in place reasonably designed to assist directors in evaluating whether a portion of fund-paid sub-accounting fees is being used to pay directly or indirectly for distribution.

  • The board should ensure that the investment adviser and other relevant service providers provide sufficient information to inform the board of the overall picture of intermediary distribution and servicing arrangements for the funds, including how the level of sub-accounting fees may affect other payment flows (such as revenue sharing) that are intended for distribution.

  • The board should carefully review the following items:

    • distribution-related activity that is conditioned on the payment of sub-accounting fees;

    • the lack of a Rule 12b-1 plan;

    • the use of tiered payment structures, in which payments typically are made first from Rule 12b-1 fees, then sub-accounting fees, and finally by the investment adviser or an affiliate;

    • a lack of specificity as to the services provided in exchange for sub-accounting fees, or payments for both sub-accounting and distribution that are bundled into a single contract;

    • taking distribution and sales benefits into account when recommending, instituting, or raising sub-accounting fees;

    • the use of disparate sub-accounting payment rates to intermediaries that may be providing substantially the same set of services; and

    • payments to intermediaries for strategic sales data.

Directors’ Outside Relationships Can Hamper Independence

Directors and management often operate in overlapping social and business networks, and care must be taken to understand the scope, depth, and duration of the personal and business relationships between directors and management, to ensure that the independence of directors is not compromised.

Key Takeaways: Typically, a director’s social and business relationships with management of a company do not strip the director of the director’s independence. However, care must be taken because in some circumstances such relationships can strip the director of his or her independence. The scope, depth, and duration of the personal and business relationships may lead a court to conclude that a director is not independent.

Summary: Directors and management often operate in overlapping social and business networks, which can be beneficial for them and for the companies that they serve. However, care must be taken to understand the scope, depth, and duration of the personal and business relationships between directors and management, to ensure that the independence of directors is not compromised.

In a Delaware Supreme Court decision, the court concluded that an outside director’s personal and business relationships with an insider created a reasonable doubt about the outside director’s independence when approving a related-party transaction. As a result, the court reversed a lower court’s ruling and thus allowed stockholders to proceed with a derivative lawsuit challenging the fairness of the transaction.

The derivative suit challenged transactions between the company and another entity that was owned by the company’s chairman and his son, who was the company’s president. The company’s board consisted of the chairman, the president, and three outside directors. In the suit, the plaintiffs had to show that a majority of the board was incapable of considering whether to bring the lawsuit. Because two of the five directors were insiders, this meant the plaintiffs had to show that at least one of the remaining three directors was not disinterested and independent.

The plaintiffs focused most of their attention on a director that had the following ties to management:

  • He and the chairman were “close friends for more than five decades”;

  • He had donated $12,500 to the chairman’s failed gubernatorial campaign;

  • Both the outside director and his brother worked as executives of a company in which the chairman was the “largest stockholder” and a non-independent director and with which the company did business; and

  • The director fees paid to the outside director constituted 30% – 40% of his total income.

The court said that allegations challenging a director’s independence must be “considered in full context” and that, while each allegation standing alone might have been insufficient, they collectively cast doubt on whether the outside director was independent of the chairman and his son. In reaching this decision, the court focused on (1) “a close friendship of over half a century” between the outside director and the chairman and (2) the fact that the chairman had “substantial influence” over the outside director’s (and his brother’s) employer, even though the chairman did not have the power to hire and fire the outside director.

So, while mere allegations that directors move in the same business and social circles as management, or that directors and management are close friends, is not enough to negate independence, there are circumstances where the scope, depth, and duration of the personal and business relationships may lead a court to conclude that a director is not independent.

Enforcement

Fiduciary Duty in Selecting Share Classes and Adhering to Compliance Policies

A recent SEC enforcement action highlights the need for investment advisers to exercise prudence in selecting share classes for their clients. In the action, the SEC found that dual-registered broker-dealers and investment advisers invested advisory clients in mutual fund share classes with 12b-1 fees instead of lower-fee share classes of the same funds that were available without 12b-1 fees, breaching their fiduciary duty to their clients.

Key Takeaways: The following are key considerations for investment advisers:

  • Conflicts of interest must be fully disclosed to clients. The primary place for this disclosure is in Form ADV and in client service agreements. Other account documentation may also be used to provide needed disclosure to clients.

  • Err on the side of over memorializing actions required to be compliant with federal securities law. While the release that adopted the rule regarding compliance programs stated that the rule does not mandate that the policies and procedures memorialize every action that is required to be compliant with federal securities law, we find that increasingly the SEC exam staff is looking for more documentation, not less.

  • Ensure that when the SEC has noted a deficiency in a prior examination that the deficiency has been corrected. Failure to correct deficiencies can be the difference in being referred to enforcement versus not being referred to enforcement.

Summary: The dual-registered broker-dealers and investment advisers invested advisory clients in mutual fund share classes with 12b-1 fees instead of lower-fee share classes of the same funds that were available without 12b-1 fees, breaching their fiduciary duty to their clients. In their capacity as broker-dealers, these firms received 12b-1 fees paid by the funds in which the advisory clients were invested. By investing these non-qualified advisory clients in the higher-fee share classes, the firms received approximately $2 million in 12b-1 fees that they would not have collected from the lower-fee share classes.

The dual-registered firms failed to disclose in their Forms ADV or otherwise that they had a conflict of interest due to a financial incentive to place advisory clients in higher-fee mutual fund share classes. In addition, the firms failed to adopt any compliance policy governing mutual fund share class selection.

The dual-registered firms disclosed in their respective Forms ADV that the firms may receive 12b-1 fees from mutual fund investments in fee-based advisory accounts. However, the firms did not disclose in their Forms ADV, or otherwise, that they had a conflict of interest with respect to selecting mutual fund share classes due to a financial incentive to place advisory clients in higher-fee share classes over lower-fee share classes of the same mutual fund. Neither the firms’ client service agreements nor any other account documentation included any such disclosure concerning mutual fund share class selection.

In addition, the dual-registered firms were found to be repeat offenders in failing to adhere to their compliance policies and procedures. Specifically, the firms failed to monitor advisory accounts quarterly for inactivity or “reverse churning” as required under their compliance policies and procedures to ensure that fee-based advisory or “wrap” accounts that charged an inclusive fee for both advisory services and trading costs remained in the best interest of clients that traded infrequently. They failed to do this even though SEC examination staff previously had cited the firms for failing to conduct such monitoring several years earlier.

As a result of the conduct described above, the SEC found that the dual-registered firms:

  • Willfully violated Section 206(2) of the Investment Advisers Act, which prohibits an investment adviser, directly or indirectly, from engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”

  • Willfully violated Section 206(4) of the Investment Advisers Act and Rule 206(4)-7 thereunder, which requires a registered investment adviser to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder.

  • Willfully violated Section 207 of the Advisers Act, which makes it “unlawful for any person willfully to make any untrue statement of a material fact in any registration application or report filed with the Commission ... or willfully to omit to state in any such application or report any material fact which is required to be stated therein.”

Penalties: The dual-registered firms were required to (1) retain an independent compliance consultant to assist in improving their compliance program, (2) pay a total of $2,049,859 consisting of disgorgement of $1,956,460 and prejudgment interest of $93,399, and (3) pay a civil monetary penalty in the amount of $7.5 million.

Funds Must be Completely Candid About Investment Strategy and Historical Performance

The SEC recently announced that a Manhattan-based investment advisory firm and its Toronto-based hedge fund manager agreed to settle charges that they misled investors about a fund’s investment strategy and historical performance.

Key Takeaways: While the investment adviser and the manager appear to have engaged in some egregious behavior, there are some key takeaways for all investment advisers and mutual funds. Failure to adhere to these takeaways may result in investment advisers and funds facing lawsuits, enforcement actions, and significant monetary penalties:

  • Funds’ disclosure about their investment strategy must be accurate, and it must be followed. 

  • In the SEC enforcement action, the investment adviser and the manager claimed that the fund followed a “five categories” strategy focusing on 285 varying metrics within the categories of momentum, growth, value, risk, and estimates. They also stated that no more than 20 percent of the fund’s assets could be invested in any single security, and that no more than 5 percent of the fund’s assets could be invested in an illiquid security. Deviation from this investment strategy led to poor performance and a further bad decision to misrepresent fund performance.

  • Historical performance must be accurate. 

  • In the SEC enforcement action, the manager provided investors with documents that reported purported historical results that were significantly higher than the fund’s actual results. In order to show these misleadingly positive returns, the manager excluded the disastrous returns he actually achieved, replacing them with the hypothetical returns that his model purportedly would have achieved if he had applied it correctly and consistently during the periods reported.

  • Any conflict of interest transactions or arrangements must be fully reviewed by the board to determine if they are permissible and in the best interests of the funds, and, if permitted, must be fully disclosed. 

  • In the SEC enforcement action, the manager did not disclose to the investors that a significant investment had been made in return for the promoters agreeing to help the adviser and the manager find clients.

Summary: The investment advisory firm and manager acted as advisers to a private investment company, or fund. They marketed the fund based on promises to follow a scientific stock selection strategy but, in practice, they repeatedly deviated from that strategy. When an early deviation led to heavy losses, the manager marketed the fund based on a misleading mixture of actual and hypothetical returns. When the investment advisory firm and manager later deviated from the strategy again, by investing most of the fund’s assets in a single penny stock, the manager failed to disclose the investment to the fund’s investors. The manager also failed to disclose that when he made the investment in the penny stock, he had a conflict of interest.

The manager subsequently used unsupported valuations of the penny stock to make the fund appear more successful than it was, thereby inducing additional investments and delaying investor redemption attempts. He also lied to investors about the fund’s liquidity when they began requesting redemptions in 2013. Through these deceptions, the manager delayed the discovery of his fraud and prolonged his ability to earn management and performance fees.

Penalties: The firms will reimburse investors $2.877 million in losses. The manager agreed to pay a $75,000 penalty and is barred from the securities industry.

© 2019 Foley & Lardner LLP

TRENDING LEGAL ANALYSIS


About this Author

Peter D. Fetzer, Securities Lawyer, Foley Lardner, Mergers Attorney
Partner

Peter Fetzer is a partner and business lawyer with Foley & Lardner LLP. His practice focuses primarily in the areas of securities regulation, mergers and acquisitions, corporate governance and general corporate counseling to mutual funds, exchange traded funds, publicly traded investment advisers and public companies.

414.297.5596
Stuart E. Fross, Foley Lardner, Securities lawyer, Finance Attorney
Partner

Stuart Fross is a partner and business lawyer with Foley & Lardner LLP where he concentrates his practice on securities laws and regulations, as part of the Private Equity & Venture Capital, Transactional & Securities and International Practices.

Mr. Fross’ main focus is investment managers and pooled investment vehicles, including U.S. registered open-end, closed end and exchange traded funds, bank collective investment funds (with an emphasis a stable value funds), UCITS funds, as well as private funds, organized in the US and offshore. Mr. Fross has extensive experience in equity, high-income and fixed income trading operations, as well as with distribution related issues for registered and unregistered funds. 

617-50-3382