For Investment Advisers:
SEC withdraws Prior Guidance on Proxy Voting Firm Independence. The SEC’s Division of Investment Management issued an Information Update officially withdrawing two no-action letters on proxy voting issued back in 2004, shortly after the adoption of Advisers Act Rule 206(4)-6. That rule, also known as the Proxy Voting Rule, requires investment advisers to adopt and implement policies and procedures for voting proxies in the best interest of clients, including a means for addressing conflicts of interest that might arise between the adviser’s interests and those of its clients. Interestingly, however, advisers are not required to vote clients on behalf of clients. If advisory firms take on that responsibility, however, then they must adopt the policies and procedures for voting and disclose them to clients. The two no-action letters, Egan-Jones Proxy Services (issued May 27, 2004) and Institutional Shareholder Services, Inc. (issued September 14, 2004), are no longer available on the SEC’s website, but they allowed advisory firms to rely on the recommendations of an independent third party for voting proxies when a conflict arose. Firms were required to perform due diligence to ensure that the proxy voting firm could make its recommendations impartially and in the best interest of clients.
This Information Update comes on the heels of SEC Chairman Jay Clayton’s announcement that staff statements “are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties.” Although the withdrawal made news, it will probably have a negligible effect on advisers’ use of proxy voting firms. For many, the administration of the voting process and the research required to understand all the issues take too much time and effort without giving clients much discernable benefit. Moreover, the Staff Legal Bulletin No. 30 on Proxy Voting was not withdrawn, which provides similar guidance on proxy voting service providers as the two no-action letters. Contributed by Jaqueline M. Hummel, Partner and Managing Director
SEC Proposes New Rule for ETF Approval. The SEC recently proposed Rule 6c-111 under the Investment Company Act of 1940 which codifies existing exemptive relief for exchange-traded funds (ETFs). The new rule would allow ETF issuers to launch their funds without having to obtain an exemptive order from the SEC. The proposed rule would apply to any ETF structured as an open-end fund and would apply to both index-based and actively managed ETFs. The proposed rule would not apply to unit investment trusts, ETFs structured as a share of a multi-class fund, and leveraged and inverse ETFs. Contributed by Jaqueline M. Hummel, Partner and Managing Director
GIPS 2020: Proposed Changes to the Standards May Make Compliance Easer: The CFA Institute recently released the revisions for the Global Investment Performance Standards (GIPS) 2020 in an Exposure Draft for public comment. One of the goals of this draft is to make the standards more accessible to alternative investment managers and managers of pooled funds since many have not embraced the standards.
The proposed changes will most directly impact:
- Asset managers that manage limited and broadly distributed funds. The Exposure Draft outlines several proposed changes applicable to firms with commingled funds. A key change is that a GIPS compliant firm would not be required to create a composite for pooled funds where the pooled fund would be the only constituent of the composite. Managers of limited distribution funds would create a GIPS Pooled Fund Report instead. The Exposure Draft allows GIPS firms to create composites that “represent the strategies the firm offers as a segregated account” and may optionally present a GIPS Pooled Fund Report for pooled funds rather than include them in a composite.
- Alternatives managers. The Exposure Draft provides options regarding the valuation of private market investments. The draft proposes three options to satisfy the external valuation requirement: (1) an external valuation, (2) review of valuation inputs by an outside party, or (3) a financial statement audit.
- Asset owners. The proposed 2020 GIPS has been reorganized so that asset owners and asset managers will now refer to specific portions of the standards applicable to their firm type, with the Advertising Guidelines applying to both and existing in a third section. This should be a welcome enhancement to asset owners who were previously forced to wade through each topical section (and requirements applicable only to asset managers) to identify the relevant portions of the standards.
Other key concept changes in the Exposure Draft include a distinction between limited and broadly distributed funds. The draft also provides more flexibility for showing performance. The draft allows GIPS firms to use different performance reports based on the type of investment vehicle: GIPS Composite Reports (the traditional GIPS compliant presentation), GIPS Pooled Fund Reports (applicable to limited and broadly distributed funds) and Asset Owners Reports.
Additional revisions include: (1) a return to permissible uses of carve-outs, (2) an option for firms to use money-weighted returns (MWR or IRR) in certain situations, (3) tweaks to the portability standards, and (4) modifications to the GIPS Advertising Guidelines that are intended to provide firms with more flexibility surrounding how they present the claim of GIPS compliance.
Timeline. To facilitate the comment process on the Exposure Draft, the CFA Institute released a separate question document. Comments can be submitted through December 31, 2018, and the adoption of the revised GIPS standards is planned for mid-2019 with an effective date of January 1, 2020. We are closely monitoring developments related to the GIPS 2020 initiative and look forward to sharing additional details with you over the coming months. Contributed by Cari A. Hopfensperger, Compliance Consultant
State of Pennsylvania Bans Advisers from using Client Usernames and Passwords for Custody Accounts. The Pennsylvania Department of Banking and Securities issued a position letter on September 25, telling state-registered investment advisers and their investment adviser representatives to stop using client usernames and passwords to access client custody accounts. (The SEC issued a similar warning in an OCIE Risk Alert in 2017.) Citing public policy concerns, the Department Staff stated that accessing a client’s custodial account through using the client’s password or username will be considered a “dishonest and unethical business practice” in Pennsylvania and a potential custody violation. Advisers currently using client usernames or passwords should take the following steps:
- Immediately stop using client usernames and
- Contact affected clients before October 25, 2018 in writing and advise the clients to change their passwords and security questions immediately.
- Retain records of the written communication to affected clients as part of the firm’s required books and records.
The deadline for compliance is October 25, 2018. Federally registered advisers should also pay attention to this notice. Although the SEC is the primary regulator for federally covered advisers, states can go after SEC-registered advisers for violations of state securities laws that amount to fraud. Department Staff in Pennsylvania intend to initiate administrative actions against advisers if it spots them using client passwords and usernames after October 25, 2018. Contributed by Carolyn W. Mendelson, Esq., Senior Compliance Consultant
For Broker-Dealers: FINRA Actions
TIME SENSITIVE ALERT FOR THIS FRIDAY, 9/28:
For Broker-dealers and Registered Investment Advisers: all pending Forms U4 and U5 that are open after 11:00 p.m. Eastern Time on Friday, September 28th will become READ-ONLY. Firms should submit any pending filings by end of business on September 28th to avoid having to re-generate new filings. Please review your Firm’s filing queues and submit pending filings as soon as possible. Here’s what is says on FINRA’s Firm Gateway:
CRD Release 2018.09 – Implementation Saturday, September 29, 2018
Release 2018.09 changes will be effective Mon., Oct. 1, 2018, and will have significant impact to firms. It will incorporate consolidated registration and qualification rule changes, the new Securities Industry Essentials (SIE) exam, revisions to the representative-level qualification exams, changes to how related information is displayed in CRD, as well as supporting changes to Forms U4 and U5.
Firms should note that this release will include changes to the “Examination Requests” and “SRO Registrations” sections of the Form U4 as well as the “SRO Partial Termination” section of the Form U5, which will support the consolidated registration rule changes. To assist firms in requesting registrations on the Form U4 SRO Registration section, a feature will be added to CRD to auto-select valid registrations previously maintained. As a result of these changes, any pending (in-process) Forms U4/U5 filings not submitted by 11 p.m.,ET, Fri., Sept. 28, will become invalidated and converted to “read-only.” Users who still need to submit any invalidated filings will have to recreate them; firms are advised to plan accordingly.
Please review the following resources:
Take Note Regarding FINRA’s New Financial Industry Affiliate Waiver Program: Since our last update, we received questions about whether participants in the new Financial Industry Affiliate Waiver Program will be required to complete Regulatory Element Continuing education during the seven-year waiver period? If yes, how will participants be notified of their continuing education obligations? The answer is to the first question is, “Of Course!” How else would FINRA be able to collect your regulatory element continuing education fees? Participants will continue to be subject to the Regulatory Element program and must complete their obligations during the 120-day CE window. FINRA will directly notify eligible individuals of upcoming Regulatory Element CE via email, and it will provide them with an interface to the FINRA CE Online System™ so that they can complete the requirement within the 120-day window. Eligible individuals will be responsible for providing FINRA their contact information, including a valid email address, and for updating such information. Eligible individuals will also be responsible for paying the CE fee. Contributed by Rochelle A. Truzzi, Senior Compliance Consultant
Does Your Firm Effect OTC Trades in Equity Securities on a Net Basis? Trading on a net basis is basically a principal transaction where the broker-dealer executes the purchase into inventory and the sale to the client simultaneously but at different prices. These are similar to riskless principal transactions as a result of timing but do not meet the definition of riskless principal transaction due to the difference in price. These transactions must comply with the following Rules based on the net price of the transaction: FINRA 2124 – Net Transactions with Customers; FINRA 2121 – Fair Prices and Commissions; FINRA 5310 – Best Execution and Interpositioning; FINRA 5320 – Prohibition Against Trading Ahead of Customer Orders; and Rule 611 of Regulation NMS – Order Protection Rule
If your firm trades in equity securities on a net basis, review the applicable section(s) of your Written Supervisory Procedures manual and ensure that the Rules listed above are addressed. Contributed by Rochelle A. Truzzi, Senior Compliance Consultant
WARNING! Contracts with Your 3rd Party Recordkeeping Service Providers May be in Violation of SEA Rule 17a-4: According to FINRA Regulatory Notice 18-31, the SEC considers contractual provisions allowing a service provider to delete or destroy a broker-dealer’s records as a result of non-payment by the broker-dealer to be inconsistent with the retention and undertaking requirements set forth in SEA Rule 17a-4. Destruction of records under such circumstances may result in SEC action against both the broker-dealer and the third party service provider. Please take a moment and review your contracts today. Contributed by Rochelle A. Truzzi, Senior Compliance Consultant
Lessons Learned from Recent SEC and FINRA Cases:
$1.9 million lesson on Back-Testing Performance: To be or not to be, that is the question . . . The Securities and Exchange Commission (“SEC”) slammed Massachusetts Financial Services (“MFS”) with a $1.9 million fine for not disclosing that a hypothetical performance chart included in institutional marketing materials, specifically a pitchbook, RFPs and a white paper, included back-tested information. MFS created its quantitative desk in 2000. However, the performance chart included quantitative performance back to 1995. “Specifically, the quantitative ratings for the period 1995-2000 for all stocks and for the period 2000-2003 for some stocks were the result of the retroactive application of MFS’s quantitative model.” The SEC stated “[b]ack-tested performance attempts to illustrate how a portfolio would have performed during a certain historical period if the portfolio had been in existence during that time. Back-tested performance carries the risk that the performance depicted is not due to successful predictive modeling.” The chart and statements regarding the performance records were found to be materially false and misleading because they were not based on original research and the firm did not disclose that the back-tested performance significantly improved the hypothetical performance.
Not surprisingly, MFS was cited for inadequate policies and procedures for reviewing the marketing materials. The internal breakdowns included miscommunication between portfolio management and compliance and the use of multiple compliance personnel, based on audience, to review the materials who did not have all the facts related to the history of the portfolios.
Or take arms against a sea of troubles. . . Using back-tested performance in marketing materials is a high-risk activity, whether a firm is dealing with sophisticated institutional investors or retail clients. The SEC views this type of information as inherently suspect, requiring copious disclosure. However, if a firm chooses to use back-tested performance, it’s critical that the materials receive continuous scrutiny such as including experienced compliance personnel in the review process, requiring the portfolio manager to sign off on the disclosures, and verifying the performance record by a third party. Contributed by Senior Compliance Consultant, Heather D. Augustine
Private Fund Adviser Fined $200,000 for Withholding Information in Buy-Out Offer. This case illustrates the perils of engaging in principal transactions. The SEC fined an investment adviser and one of its principals $200,000 for failing to disclose a potential increase in fund assets when making a buy-out offer. This story starts out with some limited partners asking for a way to exit a 17-year old fund, the VS&A Communications Partners III, L.P. (the “Fund”). The Fund’s investment committee decided to dissolve the Fund through a distribution-in-kind. A principal of the Fund, Jeffrey Stevenson, apparently still believed in the remaining portfolio companies and offered to buy the limited partners’ interests for cash equal to 100 percent of Fund’s audited net asset value as of December 31, 2014. The majority of the limited partners accepted this offer in April 2015. In early May 2015, the Fund’s investment committee learned that the two remaining portfolio companies had done well in the first quarter, indicating, at least preliminarily, a material increase in the Fund’s net asset value. VSS Fund Management LLC (“Fund Adviser”), the Fund’s adviser, rescinded the offer for the distribution in-kind and told the limited partners that it would keep the Fund open for those who wanted to remain invested. Those who wanted out of the Fund could accept the offer from Stevenson to purchase their interests on the same terms as previously provided. About 80 percent of the limited partners decided to take the cash.
The SEC found that the Fund Adviser and Stevenson misled the limited partners since they failed to disclose the Fund’s potential increase in net asset value. These omissions were violations of Section 206(4) of the Advisers Act and Rule 206(4)-8, which prohibit advisers from engaging in fraudulent, deceptive or manipulative behavior. The lesson learned in this case is that an adviser can never have too much disclosure when engaging in a transaction with investors. Even if the Fund Adviser had doubts about the increase in net asset value, it should disclose the information to the investors to ensure fairness. Contributed by Jaqueline M. Hummel, Partner and Managing Director
Putting the Cart Before the Horse: Transamerica Sells Quant Funds with Untested Model and SEC Blames Management. In this series of three cases, the SEC charged four Transamerica entities and two principals with misleading investors about a quantitative model being used to manage assets, resulting the firms having to distribute $97.6 million to affected investors. Apparently, the model developed by an inexperienced junior analyst “contained numerous errors, and did not work as promised,” according to the SEC’s press release. This case is eerily reminiscent of the Axa Rosenberg Group case back in 2011. Both cases involve a quantitative model used to manage client assets. In the Axa Rosenberg case, an error was discovered in the model two years after it was introduced. Management was informed and the error was fixed, but the firm made no public disclosure and clients lost money. In the Transamerica case, the administrative order asserts that AEGON USA Investment Management, LLC (“AIUM”) put a newly minted MBA in charge of developing a quantitative model that was used in some mutual funds and other investment products, all without testing the model. Internal audit identified issues with the model early on, but the investment products were launched anyway, with the promise that the firm would develop a model validation policy in short order.
Ultimately AIUM stopped using the models, but failed to disclose the change in investment strategy to investors, or disclose the errors in the model.
Two members of firm management, Bradley Beman, Chief Investment Officer for AEGON USA Investment Management, LLC (“AUIM”), and Kevin Giles, AUIM’s Director of New Initiatives, were found personally liable. These two were responsible for managing the risks associated with the model-driven strategy but apparently failed. They were fined $75,000 and $25,000, respectively.
Despite all the media emphasis on the development of the model by an inexperienced junior analyst, the heart of the SEC’s case against Transamerica and its related entities dealt with the cover-up that took place after the issues with the model were identified. A key takeaway from this case is when advisers reserve the greatest rewards for sales and impose no consequences for failures to address risk and compliance issues; they are guaranteed to have regulatory issues. Contributed by Jaqueline M. Hummel, Partner and Managing Director
The Weakest Link in Identity Theft: Your Own Employees: The case involving Voya Financial Advisors, Inc. (“VFA”), shows how vulnerable advisers can be to criminals trying to steal customer funds. Over a six-day period in 2016, fraudsters impersonating VFA representatives were able to get VFA’s technical support staff to reset their passwords. According to the SEC, the intruders were then able to get access to personal information of at least 5,600 of VFA’s customers and account information for three customers. No unauthorized transfers resulted from the attack. This is the first case the SEC has brought SEC involving Regulation S-ID, the Identity Theft Red Flags Rule. VFA agreed to pay a $1 million fine and retain an independent compliance consultant to review its policies and procedures to ensure compliance with Regulation S-P and Regulation S-ID.
The case is a good case study showing how the intruders were able to exploit the vulnerabilities in the system. According to the SEC order, VFA’s inadequate cybersecurity procedures resulted in not shutting off the intruders’ access to VFA’s systems quickly after the breach. The case also illustrates that training on information protection is essential; staff should understand how to identify intruders and what steps to take to stop them. Our advice: read the case and learn from VFA’s mistakes. Contributed by Jaqueline M. Hummel, Partner and Managing Director
Radio Show Host gets Advisor in Hot Water for Glowing Review. As any compliance officer can tell you, advertising for investment advisers is a tricky business. There are, however, a couple of things that are clearly forbidden under Rule 206(4)-1, the “Advertising Rule” and the first is using a client testimonial in an advertisement. Creative Planning, Inc., and its president, Peter Mallouk, agreed to pay a $200,000 penalty to the SEC for a violation of Rule 206(4)-1(a)(1) under the Advisers Act which prohibits the use of client testimonials in advertisements.
Creative Planning, Inc. (“Creative”) advertised its services on a local radio station where the radio host would discuss the firm’s services live on the air. Creative gave the station specific instructions to use content from its compliance-approved pre-recorded spots. One of the radio hosts became a client of Creative and began discussing his satisfaction with the service provided as part of the on-air advertisement. Apparently, no one at Creative listened to this station or requested recordings of the live ads, so no one at the firm was aware of these ad hoc testimonials, which aired over 200 times over a two-year period.
The obvious lesson from this case is to monitor your firm’s advertisements to ensure that they are being presented in compliance with SEC regulation. Peter Mallouk discusses what he learned from this experience — check it out here. Contributed by Jaqueline M. Hummel, Partner and Managing Director
Earning the Right to Get Swindled: Matt Levin from Bloomberg provides a new approach for defining “accredited investor.”
Urban Meyer, Ohio State Football, and How Leaders Ignore Unethical Behavior: David M. Mayer discusses how biases get in the way of ethical conduct.
The other side of the story: Peter Mallouk, CEO of Creative Planning, discusses the hard lessons he learned as a result of SEC action against his firm.
Get Yer Ya Yas Out: Thomas Fox, the Compliance Evangelist, writes a great blog post about how important it is to find compliance officers with curiosity, and encourage your staff to continuously learn and ask questions.
Five Social Media Cybersecurity Updates you Can Address Now: Scott Kleinberg at InvestmentNews provides some simple advice on protecting your firm from cybercriminals.
Report on State of IA Industry Released: Lorna Schnase provides her take on the report from National Regulatory Services and the Investment Adviser Association.
2018 Evolution Revolution: Check out NRS and Investment Adviser Association’s report on the state of the investment adviser profession.
Filing Deadlines and To Do List for October 2018
FOR INVESTMENT MANAGERS AND HEDGE/PRIVATE FUND MANAGERS
- Form 13H: Amendment to Form 13H due promptly for advisers that already have a Form 13H filing obligation and have changes to any of the information reported.
- Recommended due date: October 10, 2018. (Note: Neither the SEC nor its staff has provided guidance on the definition of “promptly” for Form 13H.)
- Form PF for Large Liquidity Fund Advisers: Large liquidity fund advisers must file Form PF with the SEC on the IARD system within 15 days of each fiscal quarter end. Filing for Q3 2018 is due October 15, 2018.
- Annual Audit Reports for the Fiscal Year-End July 31, 2018: FINRA requires that member firms submit their annual audit reports in electronic form. Firms must also file the report at the regional office of the SEC in which the firm has its principal place of business and the SEC’s principal office in Washington, DC. Firms registered in Arizona, Hawaii, Louisiana, or New Hampshire may have additional filing requirements. Due date is October 2, 2018.
- Supplemental Inventory Schedule (“SIS”): For the month ending August 31, 2018. The SIS must be filed by a firm that is required to file FOCUS Report Part II, FOCUS Report Part IIA or FOGS Report Part I, with inventory positions as of the end of the FOCUS or FOGS reporting period, unless the firm has (1) a minimum dollar net capital or liquid capital requirement of less than $100,000; or (2) inventory positions consisting only of money market mutual funds. A firm with inventory positions consisting only of money market mutual funds must affirmatively indicate through the eFOCUS system that no SIS filing is required for the reporting period. Due date is October 2, 2018.
- SIPC-3 Certification of Exclusion from Membership: For firms with a Fiscal Year-End of August 31, 2018 AND claiming an exclusion from SIPC Membership under Section 78ccc(a)(2)(A) of the Securities Investor Protection Act of 1970. This annual filing is due within 30 days of the beginning of each fiscal year. Due date is October 2, 2018.
- SIPC-6 Assessment: For firms with a Fiscal Year-End of February 28, 2018. SIPC members are required to file for the first half of the fiscal year a SIPC-6 General Assessment Payment Form together with the assessment owed within 30 days after the period covered. Due date is October 2, 2018.
- SIPC-7 Assessment: For firms with a Fiscal Year-End of July 31, 2018. SIPC members are required to file the SIPC-7 General Assessment Reconciliation Form together with the assessment owed (less any assessment paid with the SIPC-6) within 60 days after the Fiscal Year-End. Due date is October 2, 2018.
- Customer Complaint Quarterly Statistical Summary: For complaints received during the 3rd Quarter, 2018. FINRA Rule 4530 requires Firms to submit statistical and summary information regarding complaints received during the quarter by the 15th day of the month following the calendar quarter. Due date is October 14, 2018.
- Rule 17a-5 Quarterly FOCUS Part II/IIA Filings: For Quarter ending September 30, 2018. FINRA requires member firms to file a FOCUS, (Financial and Operational Combined Uniform Single) Report Part II or IIA on a quarterly basis. Clearing firms and firms that carry customer accounts file Part II and introducing firms file Part IIA. Due date is October 24, 2018.
- Quarterly Form Custody: SEC requires that member firms file Form Custody pursuant to SEA Rule 17a-5(a)(5) for the quarter ending September 30, 2018. Due date is October 24, 2018.
- Supplemental Statement of Income (“SSOI”): For the quarter ending September 30, 2018. FINRA requires firms to submit additional, detailed information regarding the categories of revenues and expenses reported on the Statement of Income (Loss) page of the FOCUS Report Part II/IIA. Due date is October 29, 2018.
- Supplemental Inventory Schedule (“SIS”): For the month ending September 30, 2018. The SIS must be filed by a firm that is required to file FOCUS Report Part II, FOCUS Report Part IIA or FOGS Report Part I, with inventory positions as of the end of the FOCUS or FOGS reporting period, unless the firm has (1) a minimum dollar net capital or liquid capital requirement of less than $100,000; or (2) inventory positions consisting only of money market mutual funds. A firm with inventory positions consisting only of money market mutual funds must affirmatively indicate through the eFOCUS system that no SIS filing is required for the reporting period. Due date is October 29, 2018.
- Annual Audit Reports for the Fiscal Year-End August 31, 2018. FINRA requires that member firms submit their annual audit reports in electronic form. Firms must also file the report at the regional office of the SEC in which the firm has its principal place of business and the SEC’s principal office in Washington, DC. Firms registered in Arizona, Hawaii, Louisiana, or New Hampshire may have additional filing requirements. Due date is October 30, 2018.
- SIPC-3 Certification of Exclusion from Membership: For firms with a Fiscal Year-End of September 20, 2018 AND claiming an exclusion from SIPC Membership under Section 78ccc(a)(2)(A) of the Securities Investor Protection Act of 1970. This annual filing is due within 30 days of the beginning of each fiscal year. Due date is October 30, 2018.
- SIPC-6 Assessment: For firms with a Fiscal Year-End of March 31, 2018. SIPC members are required to file for the first half of the fiscal year a SIPC-6 General Assessment Payment Form together with the assessment owed within 30 days after the period covered. Due date is October 30, 2018.
- SIPC-7 Assessment: For firms with a Fiscal Year-End of August 31, 2018. SIPC members are required to file the SIPC-7 General Assessment Reconciliation Form together with the assessment owed (less any assessment paid with the SIPC-6) within 60 days after the Fiscal Year-End. Due date is October 30, 2018.
- Form OBS: For the Quarter ending September 30, 2018. Unless subject to the de minimis exception, all clearing, self-clearing, and carrying firms and those firms that have a minimum dollar net capital requirement equal to or greater than $100,000 and at least $10 million in reportable derivatives and other off-balance sheet items must submit Form OBS as of the last day of a reporting period within 22 business days of the end of each calendar quarter via eFOCUS. Firms that claim the de minimis exemption must affirmatively indicate through the eFOCUS system that no filing is required for the reporting period. Due date is October 31, 2018.
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