Broker Dealer Regulation | Investment Adviser Regulation | Mutual Funds | NFA | Private Funds | Regulatory Deadlines | SEC Rule changes

NJ Joins Other States to Protect Seniors, NASAA Warns Smaller Advisers about Cybersecurity Risks, SEC Settles Valuation, Fund Expense & Wrap Fee Actions, and Advice on Returning to the Office: Regulatory Update for June 2020

For Investment Advisers and Broker Dealers

New Jersey Adopts Its Own Senior Safe Legislation.  New Jersey recently joined Congress, more than 25 other states and FINRA by enacting a new financial exploitation law designed to protect its vulnerable adult population from financial fraud. The New Jersey statute became effective on April 12, 2020.

The “Safeguarding Against Financial Exploitation Act” requires broker-dealers and investment advisers, through their qualifying personnel, to promptly report suspected financial exploitation of a vulnerable adult or senior citizen to the New Jersey Bureau of Securities and applicable local level adult protective services.  Moreover, the law calls for a broker-dealer, agent, investment adviser, investment adviser representative, or person who serves in a supervisory, compliance, legal, or senior investor protection capacity to also notify a trusted contact or third party previously designated by the vulnerable adult about suspected exploitation against the account holder (so long as the trusted contact is not a suspected perpetrator).  In New Jersey, a firm may temporarily hold disbursements or transactions from a vulnerable client’s account for up to fifteen business days, and potentially longer, under direction from the Bureau of Securities, a county protective services’ provider, or court order.

New Jersey joins California, Texas, Ohio, and other states with significant populations in the fight to protect their senior and vulnerable adult populations at personalized, local levels.  Refer to the NJ Bureau of Securities for more details about this legislation and how to comply with it.  Contributed by Carolyn W. Mendelson, Senior Compliance Consultant.

For Investment Advisers

NASAA 2020 Investment Adviser Section Annual Report. North American Securities Administrators Association (NASAA) issued its Investment Adviser Section Annual Report that includes statistics about state-registered investment advisers and results of examinations.  NASAA compiled results of 1,078 state examinations from the first six months of 2019.  Although books and records issues topped the list of deficiencies (59% of deficiencies), NASAA was most concerned about cybersecurity, which ranked fourth (26% of deficiencies).  According to the report, “[s]maller companies are low hanging fruit for cybercriminals, and when you consider that more than three-fourths of the nearly 18,000 state-registered investment advisers are 1- to 2-person shops, it is clear how important cybersecurity should be for these small businesses as well.”  To help these smaller advisers, NASAA developed a Cybersecurity Checklist and guidance on understanding how to use it.  Another great resource for smaller advisers is the list of Recommended Best Practices for Investment Advisers discussed on page 5 of the report.  The 11 practices cited are an excellent starting point for a compliance program.  Contributed by Jaqueline M. Hummel, Partner and Managing Director.

For Hedge Fund Managers:  NFA Actions

Notice to Members I-20-20: Coronavirus Update – Relief from Fingerprinting Requirements.  COVID-19 concerns led NFA to suspend its fingerprinting services temporarily in March.  In April, the CFTC granted corresponding temporary no-action relief from its fingerprinting requirements for natural person principals and associated persons (APs).  Other background check-related requirements still apply, and all persons relying on the relief will be required to submit fingerprints within 30 days of NFA’s announcement that fingerprint processing will resume.   Contributed by Mark L. Silvester, Compliance Associate.

Notice to Members I-20-18:  Amendments to NFA Compliance Rule 2-29 and Related Interpretive Notice Now Effective.  The NFA amended Compliance Rule 2-29 and Interpretive Notice 9003 to allow CTA Members who are also SEC-registered investment advisers (RIAs) flexibility in their use of past performance in promotional materials.  A previous update to this rule and Interpretive Notice required CTA Members to present past performance returns net of all commissions, fees and other expenses.  However, RIAs may otherwise present gross-of-fees returns to sophisticated parties in one-on-one presentations in reliance on SEC no-action relief issued to the Investment Company Institute (No-Action Letter 88-330-CC, 9/23/88).  These amendments codify similar relief.  Namely, CTA Member RIA firms may present past performance to eligible contract participants (ECPs) on a gross-of-fees basis in non-public, one-on-one presentations with proper disclosure.  CTA’s doing so must also offer to provide the ECP client with net-of-fee returns agreed upon by the firm and the ECP client at the time of or before exercising discretion over the account.  The amendments are effective immediately.  The amendments are effective immediately.  Contributed by Mark L. Silvester, Compliance Associate.

Lessons Learned 

Broker-Dealer Recruiting Tactics Lead to Reg S-P Violations.  Kestra Investment Services, LLC (“Kestra”) conducts general securities business, has 678 branch offices, and approximately 1,846 registered representatives.  Before this matter, the Firm did not have any relevant disciplinary history with any regulators.  According to the FINRA Letter of Acceptance, Waiver and Consent (AWC) Kestra violated FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade) when it caused registered representatives and their broker-dealers to violate the SEC’s Regulation S-P (Privacy of Consumer Financial Information).  From late 2017 through early 2019, Kestra required 68 recruited representatives to take nonpublic personal customer information from their broker-dealers prior to joining Kestra.  Some of the information collected, without customer or broker-dealer consent, included social security numbers, driver’s license numbers, account numbers and other confidential financial details.  As a result, Kestra was censured and fined $125,000.  Contributed by Doug MacKinnon, Senior Compliance Consultant. 

“May” I? No, You “May” Not!  SEC Settles with Private Equity Adviser with Conflicted Expense Reimbursements.  Many firms have scrubbed the word “may” from their Form ADV Part 2A disclosures and this case proves it’s worth the effort.  The SEC recently cited an investment adviser for fraud for using “may” inappropriately in its disclosures, going so far as calling the firm out for not properly updating its Summary of Material Changes.

Monomoy Capital Management, L.P. (“Monomoy”) was charged with “willfully” violating Section 206(2) of the Investment Adviser’s Act.  From April 2012 to December 2016, Monomoy charged the portfolio companies in the three private funds it managed (the “Funds”) for services from its in-house Operations Group instead of covering the costs from the management fee.  In fact, Monomoy was reimbursed for the cost of Operations Group services, accounting for approximately 13.3% of its revenue.

The Funds’ Limited Partners Agreements (“LPAs”) disclosed that the portfolio companies were responsible for paying Monomoy certain fees like closing, investment banking, placement, monitoring, consulting, director and other similar fees, but were silent on paying for Operations Group services.  The SEC contended that Monomoy did not fairly disclose the charges, or the associated conflicts of interest, and did not obtain informed consent from the limited partners.  The SEC went on to state that “In March 2014, Monomoy filed a Form ADV that disclosed “under specific circumstances, certain Monomoy operating professionals may provide services to portfolio companies that typically would otherwise be performed by third parties,” and that “Monomoy may be reimbursed” for costs related to such services.  Monomoy was, in fact, providing these services and being reimbursed for them at the time of this disclosure.  Twisting the knife in the wound, the SEC also cited Monomoy for not including these disclosures in its Form ADV Part 2A Summary of Material changes!  This case serves as a good reminder for firms to review their revenue sources for conflicts of interest and include appropriate disclosure in offering documents and Form ADV.  Monomoy agreed to pay $1.9 million in disgorgement, penalties and interest for their lapse.  Contributed by Heather D. Augustine, Senior Compliance Consultant.

Whoops!  I Did It Again!  Adviser Fails to Learn from Mistakes, Blows up Fund.  Marko Dimitrijevic, majority owner and Chief Investment Officer at Everest Capital LLC, and manager of the Everest Capital Global Fund, L.P. (the “Fund”), made the same mistake twice.  The second time around, however, the mistake resulted in blowing up the Fund, requiring the firm to repay investors $2 million, and pay a penalty of $750,000.  The Fund was formed in August 1997 and incurred some massive losses in 1998 as a result of being overly concentrated in Russian investments.  Despite this rocky start, the Fund attracted investors, reaching $830 million at its peak.  Dimitrijevic vowed not to make the same mistake, telling investors that the Fund would be subject to strict geographic limits to prevent excessive concentration.  Everest and Dimitrijevic told investors that the Fund would invest primarily in equities, but with expansive authority to invest in currencies, commodities and debt.  The Fund’s disclosure documents also stated that there were no restrictions on the Fund’s use of leverage.

The SEC focused on the five-month period just before the Fund blew up, where the marketing materials used with prospective and existing investors touted the Everest Capital’s risk controls and the Fund’s strict geographic limits on investments to prevent excessive concentration.  From September 2014 through January 15, 2015, Dimitrijevic, as portfolio manager, began making currency bets by investing in the euro to Swiss franc exchange rate.  Investors were not told about what had become a massive exposure to currency risk.  On January 15, 2015, everything fell apart.  In a surprise move, the Swiss National Bank removed a cap on the currency’s value against the euro, which caused the Swiss franc to rise more than 30% versus the euro.  The Fund’s counterparties forced Everest Capital to liquidate its positions due to margin call.  The Fund’s losses exceeded its assets and shortly thereafter, Everest Capital closed the Fund.

I suspect there is a lot more to this story.  Dimitrijevic’s firm had survived more than 25 years, longer than many other hedge fund managers.  Moreover, the Swiss National Bank’s move to remove the cap on the Swiss franc’s value was unexpected, and many investment banks, retail currency brokers and other hedge funds reported losses as a result of this move.  Although the SEC case does not specify total losses to investors, a repayment of $2 million and a $750,000 fine, imposed five years after the fact, seems like a comparatively small punishment.  Everest Capital warned investors that they could lose their entire investment, stating in fund offering documents and the firm’s Form ADV Part 2A that the firm may try to hedge its risk [of non-US investments] by investing in foreign currencies, options, and derivative contracts, “but there can be no assurance that such strategies, if implemented, will be effective.  These investment strategies and methods of operation involve the risk of loss to Advisory Clients and Advisory Clients should be prepared to bear the loss of their entire investment.”  Despite this rather stern warning, the SEC focused instead on the firm’s “inconsistent disclosures regarding investment concentration and risk controls” to support its finding that Everest Capital and Dimitrijevic violated the anti-fraud provisions of Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8.  Contributed by Jaqueline M. Hummel, Partner and Managing Director.

Five Million Reasons Why Wrap Fee Transparency is Important.  As we’ve learned from the COVID-19 pandemic, government transparency is essential to keeping citizens’ trust. For an investment adviser, disclosing fees is the equivalent, and achieving transparency is more complicated for firms sponsoring wrap fee programs.  Driving that point home, the SEC handed down a $5 million penalty to Morgan Stanley Smith Barney (MSSB) for misleading clients in its retail wrap fee programs on trade execution services and transaction costs.

During a nearly five-year period from October 2012 to June 2017, MSSB distributed disclosures, marketing materials and client communications that stressed fee transparency, leading customers to believe that they were unlikely to incur additional trade execution costs beyond the wrap fee.  In reality, however, some wrap managers frequently placed trades with third-party broker-dealers (step-out trades), and some of these third-party brokers charged clients transaction fees that were not covered by the wrap fee.

Although MSSB disclosed to clients that the wrap fee would not always cover brokerage commissions for trading away, the trade confirmations provided to clients did not identify these additional transaction-based costs.  So, despite all the disclosure about “transparency” in the Form ADV, the client agreement, and marketing materials, MSSB’s wrap clients had no way to find out how much extra they were paying for step-out trades.  Ultimately, the SEC found that MSSB violated Section 206(2) of the Advisers Act (the anti-fraud provision) and Section 206(4) and Rule 206(4)-7 for failing to adopt and implement policies and procedures designed to prevent violations of the Advisers Act.

Perhaps the greatest parting advice is to assign one person (or a team for a large organization) to oversee all moving parts, especially for practices with a higher regulatory risk such as the use of step-out trading in wrap programs.  In this case, the left hand (marketing, legal, compliance) didn’t know what the right hand (operations, wrap fee managers) were really doing.  You don’t know what you don’t know, but with adequate personnel in place to oversee, this risk can be mitigated.  Be aware that mutual funds and variable annuities can also lead to similar traps.  Contributed by JoAnna J. Halenda, Compliance Consultant.

Mutual Fund Manager Misprices Odd Lot Bonds, Overstates NAV and Related Performance.  In a unique flavor of enforcement action, the SEC found that fund manager, Semper Capital Management, L.P. (“Semper”), caused the overvaluation of residential mortgage-backed bonds held by its open-end mutual fund.  And in an ironic nod to the firm’s name (Semper means “always” for those who never learned Latin), the SEC never tires of pursuing valuation issues.  The fund’s investment strategy hinged on acquiring odd lots of mortgage-backed bonds, often trading at a discount to round lots of the same bond.  While technically the same security, the market for odd-lot pieces is much smaller than round lots of the bond, and trading odd-lot positions requires substantially more effort and patience.  Simply put, odd-lot bonds are worth less in the market than round-lot bonds.  Semper used round-lot pricing for its odd-lot bonds, and the SEC found that this practice led Semper to overstate the fund’s net asset value (“NAV”) and its performance.  Semper also did not disclose that its valuation practices for odd-lot bonds were a material contributor to the fund’s returns.  Finally, Semper failed to adopt policies and procedures that were reasonably designed to address the fund’s public disclosures concerning the attribution of returns.

It is critical that compliance personnel understand the instruments traded by their firm, how (or from where) security prices are obtained, and how performance is calculated to ensure that compliance monitoring is effective.  At first glance, a fixed-income fund holding publicly-traded bonds priced using a third-party vendor may not raise an eyebrow.  However, this case demonstrates the value of digging deeper to uncover less obvious but potentially more dangerous risks.  Contributed by Cari A. Hopfensperger, Senior Compliance Consultant.

Worth Reading

Filing Deadlines and To-Do List for June 2020

INVESTMENT MANAGERS 

  • GIPS Notification Requirement: Firms opting to comply with the Global Investment Performance Standards (GIPS) must notify the CFA Institute of its claim of compliance on an annual basis. This notification is due June 30, 2020, and should be submitted by completing the appropriate online form for on the CFA Institute’s website.
  • Form CRS: Advisers to Retail Clients must file initial Form CRS as ADV Part 3 via IARD by June 30, 2020.  Advisers must also begin delivering Form CRS to all new and prospective retail clients on this date.  Refer to Hardin’s dedicated Regulation Best Interest (Reg BI) page for templates and additional information.
  • Annual Entitlement User Certification: FINRA requires firms to conduct an annual review of its IARD user accounts and ensure that access and entitlements are appropriate for each user’s role and responsibilities. The Super Account Administrator (“SAA”) is responsible for conducting the review, amending and deleting user accounts/entitlements as necessary, and submitting the certification through IARD.  Only the SAA has access to this certification, and a Quick Reference Guide to the entitlement process is available on the IARD site.  This year, the certification period opened on April 20th and must be completed by July 20, 2020.

HEDGE/PRIVATE FUND MANAGERS

  • Blue Sky Filings (Form D):  Advisers to private funds should review fund blue sky filings and determine whether any amended or new filings are necessary.  Generally, most states require a notice filing (“blue sky filing”) within 15 days of the first sale of interests in a fund, but state laws vary.  Did you know that Hardin Compliance Consulting offers a convenient and economical blue-sky filing service to help firms manage this complicated monthly task?  Learn more here and give us a call to discuss your needs further.  Due June 15, 2020.
  • Distribute Audited Financial Statements for Private Funds:  Funds of Funds: Private fund investment advisers should have their funds audited by an independent, PCAOB-registered accountant and deliver the audited financial statements to the funds’ investors within 120 days of the end of the funds’ fiscal year. The deadline for private funds that are fund of funds is 180 days of the funds’ fiscal year-end. That’s June 29, 2020, for funds with December 31 year-end.

BROKER-DEALERS  (* Filing extensions may be available)

  • Annual Audit Reports for Fiscal Year-End March 31, 2020: 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 June 1, 2020.
  • Rule 17a-5 Monthly and Fifth FOCUS Part II/IIA Filings*: For the period ending May 31, 2020.  For firms required to submit monthly FOCUS filings and those firms whose fiscal year-end is a date other than a calendar quarter.  Due June 23, 2020.
  • Supplemental Inventory Schedule (“SIS”)*: For the month ending May 31. 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 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 June 26, 2020.
  • SIPC-7 Assessment: For firms with a Fiscal Year-End of April 30, 2019. 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 June 29, 2020.
  • Annual Audit Reports for Fiscal Year-End April 30, 2020: 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 June 29, 2020.
  • SIPC-3 Certification of Exclusion from Membership: For firms with a Fiscal Year-End of May 31 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 June 30, 2020.
  • SIPC-6 Assessment: For firms with a Fiscal Year-End of November 30. 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 June 30, 2020.
  • Form CRS Relationship Summary: Form CRS and its related rules require SEC-registered investment advisers and SEC-registered broker-dealers to deliver to retail investors a brief customer or client relationship summary that provides information about the firm.  Firms must file their relationship summaries with the Commission.  Due June 30, 2020.
  • Annual Entitlement User Account Certification: FINRA requires firms to conduct an annual review of the FINRA application user accounts established for firm personnel and ensure that access and entitlements are appropriate for the personnel’s role and responsibilities.  The Super Account Administrator (“SAA”) is responsible for conducting the review, amending and deleting user accounts/entitlements as necessary, and submitting the certification through WebCRD.  Only the SAA has access to this certification.  Notifications were delivered to the SAAs on or around April 20thDue July 20, 2020.

REGISTERED COMMODITY POOL OPERATORS

  • Form CPO-PQR (March 31 Quarter End): Small, Mid-Sized and Large Commodity Pool Operators are required to file NFA Form CPO-PQR quarterly with the NFA. The due date is May 30, 2020.  No action relief extending this due date is available – see NFA Notice I-20-15 for details.

MUTUAL FUND ADVISERS

  • Form N-PORT (Large Fund Complexes):  Large fund families (those with greater than $1 billion in assets) must file Form N-PORT reporting month end information for each month-end in each fiscal quarter no later than 60 days after fiscal quarter-end.  For funds with a March 31 fiscal quarter end, the due date is June 1, 2020.  Funds must also prepare the information reported on Form N-PORT within 30 days after every month-end and retain these records, which are subject to SEC inspection.
  • Form N-MFP:  Form N-MFP (Monthly Schedule of Portfolio Holdings of Money Market Funds) reports information about the fund’s holdings as of the last business day of the prior calendar month and must be filed no later than the fifth business day of each calendar month.  Due date is June 5, 2020.
  • Form N-PORT (Small Fund Complexes, March 31 Fiscal Quarter End):  Small fund families (those with less than $1 billion in assets) with a fiscal quarter end of March 31, must file Form N-PORT reporting month end information for each month-end in each fiscal quarter no later than 60 days after fiscal quarter-end.  In this initial filing, Form N-PORT funds need only report information for the month ending March 31, 2020.  Due date is June 1, 2020Funds must also prepare the information reported on Form N-PORT within 30 days after every month-end and retain these records, which are subject to SEC inspection.
  • Form N-PORT (Small Fund Complexes, April 30 Fiscal Quarter End):  Small fund families (those with less than $1 billion in assets) with a fiscal quarter end of April 30, must file Form N-PORT reporting month end information for each month-end in each fiscal quarter no later than 60 days after fiscal quarter-end.  In this initial filing, Form N-PORT funds need only report information for the months of March and April 2020.  Due date is June 29, 2020Funds must also prepare the information reported on Form N-PORT within 30 days after every month-end and retain these records, which are subject to SEC inspection.

____________________________________________________________________________________

Partner with Hardin Compliance

Have a compliance question or want an independent review of your compliance program?  Hardin Compliance can help!  Call us today at 1.724.935.6770, or visit our website at www.hardincompliance.com for more information.

____________________________________________________________________________________

Hardin Compliance Consulting provides links to other publicly-available legal and compliance websites for your convenience. These links have been selected because we believe they provide valuable information and guidance.  The information in this e-newsletter is for general guidance only.  It does not constitute the provision of legal advice, tax advice, accounting services, or professional consulting of any kind.

Photo by Domenico Loia on Unsplash.