FINRA Rule Changes | Form ADV | Private Equity | Regulatory Deadlines

Regulatory Update September 2016

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 SEC Adopts Amendments to Form ADV*:  In a stunningly quick move for a regulator, the SEC adopted changes to Form ADV only a little more than a year after they were proposed.  The SEC adopted amendments to the Form ADV requiring investment advisers to provide more detailed information about their separately managed account business, including aggregate data related to the use of borrowings and derivatives.  The SEC will also require disclosure about other areas of the advisory business, including branch office operations and the use of social media.  The amendments also create a process for private fund entities to register affiliated entities operating as a single advisory business.  The amendments will be effective on October 1, 2017.

FINRA Proposes Changes to Rules on Gifts, Entertainment and Non-Cash Compensation.  FINRA issued Regulatory-Notice 16-29, proposing an increase to the current gift limit from $100 to $175 per recipient, per year.  The proposal also extends FINRA’s non-cash compensation regulation to cover sales of all securities products, and requires FINRA members adopt written policies and procedures relating to oversight of business entertainment.

Investment Advisers Get Nailed for Failing to Verify Performance of F-Squared.  The SEC believes firms should do their homework before advertising performance of other investment advisers.  The SEC found that 13 investment advisers negligently relied on claims by F-Squared Investments that its AlphaSector strategy for investing in exchange-traded funds (ETFs) had outperformed the S&P Index for several years.  F-Squared admitted that the track record it presented as its own was actually back-tested performance that was substantially inflated.  The firms repeated many of F-Squared’s claims and recommended the investment to their own clients, without performing due diligence to substantiate the performance being advertised.  The penalties assessed ranged from $100,000 to a half-million dollars based upon the fees each firm earned from AlphaSector-related strategies.

SEC Continues to Target Private Equity Firms for Misleading Investors about Fees and Failure to Supervise Resulting in a $52.7 million settlement.  In yet another case of what old case books would call res ipsa loquitor1 (the thing speaks for itself), the SEC found that an adviser’s policies and procedures were insufficient since they did not stop what the SEC considers wrong-doing.  The SEC recently announced a $52.7 million settlement with four private equity fund advisers affiliated with Apollo Global Management for failing to properly disclose the acceleration of portfolio monitoring fees and certain affiliated loan interest accruals, and failing to prevent the reimbursement of unauthorized personal expenses.  Although the portfolio monitoring fees were disclosed to investors, the SEC nailed the firm for failing to disclose its practice of accelerating such fees upon sale or IPO until after the commitment of capital and receipt of fees.  Significantly, the SEC also found one of the firms failed to adequately supervise a senior partner at the firm.  The partner was twice caught improperly charging personal items and services to Apollo-advised funds and their portfolio companies.  The firm verbally reprimanded the partner and required him to repay the improperly submitted expenses, but took no other action.  When an independent expense review uncovered even more personal expenses being improperly charged to fund clients by that partner, the partner entered into a separation agreement with the firm.  Apollo self-reported this to the SEC, and this is probably why no additional fines were imposed.

Another SEC action against a Private Equity Firm for Misallocation of Fees.  Investment adviser WR Ross agreed to pay $2.3 million to settle charges made by the SEC and reimburse investors to the tune of $11.8 million.  W.L. Ross & Co. LLC is an investment adviser that managed a number of private equity funds.  The private fund documents stated that management fees to W.L. Ross would be offset by transaction fees received for services related to the portfolio companies.  Over a ten-year period, the SEC alleged that a portion of these transaction fees were paid to co-investors, which reduced the amount of the offset to fund investors.  The firm self-reported the issue during an SEC exam.  Private fund advisers should consider the steps taken by W.L. Ross to remediate the issue, including:

  • Replacing the Chief Compliance Officer and giving the new CCO a seat on key committees,
  • Engaging an independent auditor to perform an independent review of its controls, and
  • Implementing a new procedure for reviewing the allocation of fees and expenses, which includes senior management, the Chief Financial Officer, and legal and compliance representatives.

SEC’s Stance on Back-tested Performance Affirmed by Circuit Court:  This case makes it abundantly clear that the SEC hates the use of back-tested performance, and disclaimers won’t save an adviser if the Commission finds the presentation misleading overall.  Key points:

  • Back-tested performance means that performance is calculated using historical data, not hypothetical assumptions (even reasonable assumptions that do not result in misleading performance numbers)
  • Calculate back-tested performance consistent with the strategy you are advertising
  • Be able to substantiate the performance claims in advertisements, even those based on information provided by third parties
  • Include substantial and prominent disclosures when using back-tested or hypothetical performance

Lowest of the low: SEC charges Hedge Fund Manager for using Terminally Ill Patients in Fraud Scheme:  The SEC charged a hedge fund manager and his firm for fraud and violating the Custody Rule for allegedly paying terminally ill people to help him take advantage of survivor options on corporate bonds to redeem them early.  Using an incredibly creepy investment strategy, Donald “Jay” Lathen and his investment fund, Eden Arc Capital Management LLC (“EACM”), purchased medium and long-term bonds and CDs with “survivor options” or “death puts” that allowed the investment to be sold back to the issuer at par plus accrued interest on the death of the holder.  The original investments were purchased at a discount, and sold back to the issuers at par by exercising the death put.  Lathen and one of his companies aptly called “Endcare” recruited about 60 terminally ill patients (specifically targeting those with less than six months to live) to purchase investments for EACM, having each become a joint owner of an account with Lathen and giving him power of attorney, for a payment of $10,000.  When a patient died, Lathen redeemed investments in the accounts by representing to issuers that he and the terminally ill individuals were joint owners of the accounts.  The SEC alleges that Lathen’s hedge fund was the true owner of the survivor’s option investments.  Issuers paid out more than $100 million in early redemptions as a result of the alleged misrepresentations and omissions.  Along with fraud, the SEC is charging Lathen with violating the custody rule by failing to properly place the hedge fund’s cash and securities in an account under the fund’s name or in an account containing only clients’ funds and securities.

 Former Deutsche Bank AG Trader Settles with SEC for Providing Inflated Bond Valuations.  The SEC found that former bond trader Tianyu “Arnie” Zhou inflated the value of certain loans by submitting inaccurate data on bond coupons to Deutsche Bank’s valuation group from 2013 to 2015.  Without admitting or denying the SEC’s findings, Zhou agreed to pay a $50,000 penalty and be barred from the industry for a minimum of three years.  It is not easy to catch an employee who understands the firm’s systems and deliberately fabricates information.  Mr. Zhou had both a strong financial incentive to show better performance and the ability to game the system, so it’s easy to see why he succumbed to temptation.  Where the stakes are this high, firms should consider bringing in other experts to evaluate information provided by a conflicted source.  


1 Res ipsa loquitor is a doctrine that infers negligence from the very nature of an accident or injury in the absence of direct evidence on how any defendant behaved.


Filing Deadlines and To Do List for September

For Investment Advisers


  •  Amended Form 13H Quarterly Filing due September 30, 2016

*Denotes article written by Hardin Compliance Consulting LLC

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.