Investment Management

Posted on Monday, June 12 2017 at 11:00 am by

Fiduciary Rule Creates Breach of Contract Claim, But No Private Right of Action

By Paul Foley and John I. Sanders

The first part of the DOL’s Conflict of Interest Rule (the “Fiduciary Rule”) went into effect on Friday, June 9th.  A large group of newly-defined “fiduciaries” are now subject to certain requirements of the Best Interest Contract (“BIC”) exemption,[1] a portion of the Fiduciary Rule that according to some commentators creates a private right of action for investors.

The creation of a private right of action is one of the investment industry’s chief concerns with the Fiduciary Rule.  Industry leaders claim that the BIC exemption creates a private right of action because it enables investors to bring breach of contract claims and class actions against the fiduciaries with whom they contract.  However, a federal judge from the Northern District of Texas flatly rejected this claim in Chamber of Commerce of the United States of America v. Hugler.[1]

The plaintiff in Hugler claimed, among other things, that the BIC exemption created a private right of action in violation of Alexander v. Sandoval, a Supreme Court case holding that only Congress, not an administrative agency, can create a private right of action under federal law.[2]  But the judge in Hugler sided with the DOL, finding that the BIC exemption does not create a private right of action, and so does not violate Sandoval.[3]  The judge reasoned that any lawsuit resulting from the breach of a BIC exemption contract would be brought under state contract law rather than federal ERISA law.[4]  The judge also noted that it is not a new concept for federal regulations to require entities to enter into written contracts with mandatory provisions; annuity owners already have enforceable contract rights against insurers, and multiple other agencies require that their regulated entities enter into written agreements with mandatory terms.[5]

Yet articles from leaders in the legal and investment industries continue to label the BIC exemption’s litigation risk as a private right of action for investors.  Fiduciaries reading these articles should keep in mind that a private right of action cannot exist under the BIC exemption because the Supreme Court’s ruling in Sandoval only allows a private right of action to be created by Congress.  Also, it is unlikely that any court will block the Fiduciary Rule on the grounds that the BIC exemption impermissibly creates a private right of action because, as pointed out by the judge in Hugler, any claims brought as a result of BIC exemption contracts would be brought under state law rather than federal law.  However, fiduciaries should be aware that the Fiduciary Rule still exposes them to litigation risk as investors can use BIC exemption contracts (which are not required to be used until January 1, 2018) to file state breach of contract claims and, potentially, class actions.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem and New York offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[1] For more information on current Fiduciary Rule and BIC Exemption requirements, see Paul Foley & John Sanders, DOL Puts Advisors on Notice: Fiduciary Rule Will be Effective June 9th, Kilpatrick Townsend: Inv. Mgmt. Blog (May 25, 2017, 9:32 PM), http://blogs.kilpatricktownsend.com/investmentmanagement/?p=321.

[1] Chamber of Commerce of the United States of Am. v. Hugler, 3:16-CV-1476-M, 2017 WL 514424 (N.D. Tex. Feb. 8, 2017).

[2] Alexander v. Sandoval, 532 U.S. 275, 286 (2001) (citing Touche Ross & Co. v. Reddington, 442 U.S. 560, 578 (1979)).

[3] Hugler, 3:16-CV-1476-M, 2017 WL 514424, at *20.

[4] Id..

[5] Id.

Posted on Tuesday, June 6 2017 at 12:13 pm by

Kokesh v. SEC:  The U.S. Supreme Court Limits SEC Disgorgement Powers

By Paul Foley and John I. Sanders

Since the 1970s, courts have regularly ordered disgorgement of ill-gotten gains in SEC enforcement proceedings.[1]  According to the SEC, this was done as a means to both “deprive . . . defendants of their profits in order to remove any monetary reward for violating” securities laws and “protect the investing public by providing an effective deterrent to future violations.”[2]  Disgorgement has been one of the SEC’s most powerful tools in recent years.[3]  Yesterday, the Supreme Court issued an opinion that significantly limits the SEC’s ability to disgorge ill-gotten gains.[4]

The question before the Supreme Court in Kokesh v. SEC was whether disgorgement, as it has been used by the SEC, constitutes a “penalty.”[5]  Under federal law, a 5-year statute of limitations applies to any “action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise.”[6]  The SEC has long argued that disgorgement does not constitute a “penalty” and, therefore, is not subject to a 5-year statute of limitations.  The Supreme Court unanimously rejected the SEC’s position by holding that disgorgement constitutes a “penalty.”[7]  As a result, the SEC will be precluded from collecting ill-gotten gains obtained by the defendant more than five years before the date on which the SEC files its complaint.[8]

In the Kokesh case, the Supreme Court’s decision means that the defendant may retain $29.9 million of the $34.9 million of allegedly ill-gotten gains because that amount was received outside of the 5-year state of limitations.[9]  The Kokesh decision is also likely to have a significant long-term impact on SEC enforcement proceedings by reducing the leverage the SEC can apply while negotiating settlements.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem and New York offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

 

[1] SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 91 (SDNY 1970), aff ’d in part and rev’d in part, 446 F. 2d 1301 (CA2 1971).

[2] Id. at 92.

[3] SEC, SEC Announces Enforcement Results for FY 2016 (Oct. 11, 2016), available at https://www.sec.gov/news/pressrelease/2016-212.html (illustrating that the SEC has obtained more than $4 billion in disgorgements and penalties in each of the three most recent fiscal years).

[4] Kokesh v. SEC, available at www.supremecourt.gov.

[5] Id. (“This case presents the question whether [28 U.S.C.] §2462 applies to claims for disgorgement imposed as a sanction for violating a federal securities law.”).

[6] 28 U.S.C. §2462 (2017).

[7] Kokesh v. SEC, supra note 4, available at www.supremecourt.gov.  (“SEC disgorgement thus bears all the hallmarks of a penalty: It is imposed as a consequence of violating a public law and it is intended to deter, not to compensate.”).

[8] Id.

[9] Id.

Posted on Thursday, May 25 2017 at 9:32 pm by

DOL Puts Advisers on Notice:  Fiduciary Rule Will Be Effective June 9th

By Paul Foley and John I. Sanders

On March 2, 2017, the DOL extended the applicability date of the Conflict of Interest Rule (the “Fiduciary Rule”) from April 10, 2017 to June 9, 2017.[1]  This week, with the extension drawing to a close, Secretary of Labor Alexander Acosta has reported that the DOL “found no principled legal basis” to delay the applicability date beyond June 9.[2]  It is now a near-certainty that the Fiduciary Rule will “go live” on that date.

Despite DOL statements about a “transition period” and a “phased approach to implementation,” the heart of the Fiduciary Rule will be effective in just two weeks.[3]  Most importantly, “investment advice providers to retirement savers will become fiduciaries.”[4]  As fiduciaries, they must provide impartial advice in the customer’s best interest and cannot accept payments creating conflicts of interest (i.e., commissions and 12b-1 fees) unless they qualify for an exemption.[5]  Among exemptions, the Best Interest Contract Exemption is especially enticing before more stringent requirements for its use go into effect on January 1, 2018.[6]  Until January 1, 2018, the only conditions for the BIC Exemption are:  (i) investment advice is in the “best interest” of the retirement investor, meaning that it is both prudent and the advice is based on the interest of the investor rather than the adviser; (ii) no more than reasonable compensation is charged; and (iii) no misleading statements are made about the transaction, compensation or conflicts of interest.[7]  After January 1, 2018, an actual contract with particular terms will be required.[8]

For many investment advisers (as opposed to broker-dealers and their registered representatives), the impending applicability of the Fiduciary Rule is not a significant concern.  The DOL has stated that a fee based on assets under management (i.e., flat asset based fees or traditional wrap fee arrangements)  typically would not raise any issues under the Fiduciary Rule.[9]  However, for investment advisers not currently employing such fee arrangements, the Fiduciary Rule likely will require changes.[10]

In an effort to calm would-be fiduciaries that will not be able to meet the June 9th deadline for compliance with the Fiduciary Rule, the DOL issued a temporary enforcement policy on May 22nd stating that it would not take any enforcement action against “fiduciaries who are working diligently and in good faith to comply with the new rule and exemptions” until January 1, 2018.[11]  The DOL also promised an enforcement approach prior to January 1, 2018 “marked by an emphasis on compliance assistance (rather than citing violations and imposing penalties).”[12]  This policy only applies to DOL enforcement actions.  Investors may still bring private actions (i.e., fraud or breach of contract claims) against those who breach their fiduciary duties, and the IRS may still impose excise taxes or seek civil penalties.[13]

With applicability of the Fiduciary Rule just two weeks away, all investment advisers should assess its applicability to them and prepare accordingly.  At a minimum, this means working with compliance staff and legal counsel to determine whether all advice given to retirement investors is:  (i) in the client’s best interest (which investment advisers, as fiduciaries should already be doing), (ii) is impartial, and (iii) does not generate payments to the investment adviser giving rise to a conflict of interest.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[1] Department of Labor,  Conflict of Interest Rule – Retirement Investment Advice; Proposed Rule; Extension of Applicability Date (March 1, 2017), available at https://www.dol.gov/agencies/ebsa/laws-and-regulations/rules-and-regulations/completed-rulemaking/1210-AB32-2.

[2] Id.

[3] Department of Labor, Conflict of Interest FAQs (Transition Period) (May 2017), available at https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/faqs/coi-transition-period.pdf.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Conflict of Interest Rule, 81 Fed. Reg. 20946, 20992 (April 8, 2016) (to be codified at 29 CFR Parts 2509, 2510, and 2550) (The DOL has stated that if an investment adviser using a flat fee or wrap fee compensation model makes recommendations that would generate additional compensation for the adviser (e.g., adviser recommends rolling an IRA into an annuity that will generate fees for the adviser), then the adviser would need to rely on an exception.)

[10] Id.

[11] Department of Labor, Conflict of Interest FAQs (Transition Period) (May 2017), available at https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/faqs/coi-transition-period.pdf .

[12] Id.

[13] Conflict of Interest Rule, 81 Fed. Reg. 20946, 20653 (April 8, 2016) (to be codified at 29 CFR Parts 2509, 2510, and 2550).

Posted on Monday, May 8 2017 at 10:38 am by

General Solicitations of Certain Regulation D “Private” Securities Offerings:  SEC Affirms Zero-Tolerance Policy.

By Paul Foley and John I. Sanders

On March 29, 2017, the Securities and Exchange Commission (the “SEC”) issued a noteworthy opinion in In re KCD Financial Inc.,[i] a review of a FINRA disciplinary action.[ii]  While the opinion affirmed FINRA’s disciplinary action,[iii] it also affirmed the SEC’s zero-tolerance policy regarding general solicitations made in the course of certain Regulation D offerings.  Those relying on or contemplating relying on Regulation D exemptions from registration should review the SEC’s opinion.

Factual Background

KCD Financial, Inc. (“KCD”) is an independent broker-dealer.[iv]  In 2011, KCD signed an agreement with one of its affiliates (“Westmount”) under which it would solicit accredited investors for a particular private fund (the “Fund”) sponsored by Westmount.[v]  Westmount did not plan to register the offering.  Westmount instead planned to rely on a Rule 506(b) exemption from registration.[vi]

Prior to KCD selling any interest in the Fund, Westmount issued a press release describing the Fund.[vii]  Two Dallas newspapers published articles based on the press release and made the articles available on their respective public websites.[viii]  One of those newspaper articles was then posted on a public website belonging to a Westmount affiliate.[ix]  Westmount’s outside counsel informed Westmount that the newspaper articles constituted general solicitations, which are prohibited in Rule 506(b) offerings.[x]

After KCD and Westmount officers were told that the articles were general solicitations prohibited under Rule 506(b), they did not end the offering, register the securities, or seek to rely on an alternative exemption.  Instead, KCD’s CCO and Westmount’s Vice President of Capital Markets instructed the representatives to sell interests in the Fund only to (i) those with an existing relationship to KCD or Westmount and (ii) accredited investors who had not learned of the offering through the general solicitations.[xi]  Under those guidelines, at least one person was refused an opportunity to purchase interests in the Fund.[xii]

During a FINRA examination of KCD, the examiner found that the newspaper article about the offering had not been removed from a Westmount-affiliated website.[xiii]  Subsequently, FINRA filed a complaint against KCD alleging that the firm’s registered representatives sold securities that were unregistered and not qualified for an exemption from registration, thereby violating FINRA Rule 2010.[xiv]  FINRA also alleged that KCD failed to reasonably supervise the offering, thereby violating FINRA Rule 3010.[xv]  FINRA’s Hearing Panel found that KCD violated those rules.[xvi]  FINRA censured KCD and imposed a fine of $73,000.[xvii]  The National Adjudicatory Counsel affirmed FINRA’s decision.[xviii]  KCD then requested an SEC review.[xix]

SEC Review

KCD admitted that the Fund interests it offered were not registered, but argued that offers were made pursuant to Rule 506(b).[xx]  The SEC rejected KCD’s contention,[xxi] finding that where a party relying on the Rule 506(b) exemption makes a general solicitation, the exemption then is unavailable “regardless of the number of accredited investors or the knowledge and experience of the purchasers who were not accredited investors.”[xxii]  In this context, whether purchasers were accredited or had prior relationships with KCD and Westmount was “irrelevant to whether or not the newspaper articles constituted a general solicitation” and precluded reliance on Rule 506(b).[xxiii]

KCD also argued, assuming the newspaper articles constituted general solicitations, it could still rely on a Rule 506(b) exemption because “KCD did not generally solicit any of the actual investors in the [Westmount] Fund.”[xxiv]  This argument confused the notion of what is prohibited under Rule 506(b).  It is making an offer by general solicitation which precludes reliance on a Rule 506(b) exemption.[xxv]  Whether a sale results directly from the general solicitation is irrelevant.[xxvi]

Practical Implications

The SEC’s opinion affirms its view that exemptions from registration in securities offerings are narrowly construed and must be adhered to strictly.[xxvii]  Where, as here, the exemption prohibits a general solicitation, any general solicitation forever forfeits the issuer’s ability to rely on the exemption in making the offering (i.e., the toothpaste cannot go back into the tube).

Those making exempt offerings in reliance on Rule 504,[xxviii] Rule 505,[xxix] and Rule 506(b)[xxx] should review their sales practices in light of the KCD opinion.  In reviewing practices, issuers should look beyond the obvious means of making a general solicitation (e.g., a press release that is published by a widely-circulated newspaper).  Websites and social media accounts of those participating in the offerings are equally capable of precluding use of a valuable registration exemption.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John I. Sanders is an associate based out of the firm’s Winston-Salem office.

[i] In re KCD Financial, Inc., SEC Release No. 34-80340 (March 29, 2017), available at www.sec.gov/litigation/opinions/2017/34-80340.pdf (hereinafter, SEC Opinion).

[ii] In re KCD Financial, Inc., FINRA Complaint No. 2011025851501 (Aug. 3, 2016), available at http:www.finra.com (hereinafter, FINRA Opinion).

[iii] SEC Opinion, supra note 1, at p. 1.

[iv] Id., at p. 2.

[v] Id.

[vi] Id.

[vii] Id, at p. 3.

[viii] Id.

[ix] Id. at p. 4.

[x] Id.

[xi] Id.

[xii] Id.

[xiii] Id.

[xiv] Id.

[xv] Id.

[xvi] FINRA Opinion, supra note 2, at p. 4.

[xvii] Id.

[xviii] Id.

[xix] Id.

[xx] SEC Opinion, supra note 1, at 2.

[xxi] Id.

[xxii] Id. at 7.

[xxiii] Id. at 9.

[xxiv] Id at 10.

[xxv] Id.

[xxvi] Id. at 11

[xxvii] Id. at 7.

[xxviii] 17 CFR 230.504 (2017).

[xxix] 17 CFR 230.505 (2017).

[xxx] 17 CFR 230.506(b) (2017).

Posted on , May 8 2017 at 9:59 am by

SEC Amends Crowdfunding Rules

By Paul Foley and John I. Sanders

Under the Jumpstart our Business Startups Acts of 2012 (the “JOBS Act”), the Securities and Exchange Commission (the “SEC”) adopted rules allowing for securities-based crowdfunding in 2015.[i]  The JOBS Act required the SEC to adjust dollar limits placed on the amount that could be invested or raised through securities-based crowdfunding at least every five years to account for inflation.[ii]  On April 5, 2017, the SEC issued a final rule adjusting those limits for the first time.[iii]  We encourage those interested in issuing securities through a securities-based crowdfunding offering to review the final rule and call us with any questions you may have.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John Sanders is an associate based out of the firm’s Winston-Salem office.

[i] SEC, Release No. 33-9974 (Oct. 9, 2015), available at https://www.sec.gov/rules/final/2015/33-9974.pdf.

[ii] Id. at 15.

[iii] SEC, Release No.33-10332 (April 5, 2017), available at https://www.sec.gov/rules/final/2017/33-10332.pdf.

Posted on Wednesday, April 19 2017 at 8:48 am by

SEC Issues Guidance to Robo-Advisers

Robo-advisers are a fast-growing segment of the investment advisory industry.  In fact, they now account for an estimated $71.5 billion in assets under management.[1]  In response to their explosive growth, the SEC has made robo-advisers an examination priority[2] and has issued regulatory guidance to them.[3]  The SEC’s guidance is summarized below.

  • Disclosures to potential clients should explain the: (i) robo-adviser’s business model and how it differs from traditional investment adviser models; and (ii) limitations in the scope of the robo-adviser’s services.[4]  The robo-adviser should also consider whether its delivery of the disclosures is clear and conspicuous enough to be effective in the context of the relationship, which may be entirely web-based.[5]
  • Questionnaires used to gather client information should be designed to obtain sufficient information to support the robo-adviser’s suitability obligation.[6] Where the client can select investments other than those the adviser recommends, the robo-adviser should provide commentary supporting its recommendations.[7]
  • Internal compliance programs should address the unique aspects of the robo-adviser business model, including limited human interaction and heightened cybersecurity risks.[8]

Advisers who have replaced or supplemented their advisory services with robo-adviser technology in recent years may have questions after reviewing the SEC’s guidance.  Please feel free to contact us with any questions you may have.

Paul J. Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

 

[1] Daisy Maxey, Spotlight on Robo Advisers’ Returns, Wall Street Journal (Nov. 1, 2016), https://www.wsj.com/articles/spotlight-on-robo-advisers-returns-1478018429.

[2] SEC, National Exam Program Examination Priorities for 2017 (Jan. 13, 2017), www.sec.gov/about/offices/ocie/national-examination-program-priorities-2017.pdf.

[3] SEC, IM Guidance Update No. 2017-02 (Feb. 2017), www.sec.gov/im-guidance-2017-02.pdf.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

Posted on Wednesday, March 8 2017 at 10:41 am by

SEC Issues Guidance to Ease Fund Implementation of “Clean Shares”

By Andrew Sachs and John I Sanders

In January, we authored a post[i] discussing an SEC no-action letter, dated January 11, 2017, to Capital Group (the “Capital Group Letter”), the parent company of American Funds.[ii]  In the Capital Group Letter, the SEC agreed that Section 22(d) of the Investment Company Act of 1940 (the “Act”), which prohibits selling securities except at “a current public offering price described in the prospectus”, does not apply to brokers when acting as agent on behalf of its customers and charging customers commissions for effecting transactions in so-called “Clean Shares”.[iii]

Clean shares are mutual fund shares stripped of any front-end load, deferred sales charge, or other asset-based fee for sales or distribution that are sold by brokers who set their own commissions in connection with such sales.[iv]  We noted in January that the ability to replace the distribution fees typically charged by its mutual funds with commissions charged by a broker would give funds a new measure of flexibility to meet the demands of the Fiduciary Rule and competition generally, and we anticipated that many mutual fund companies would explore the concept of Clean Shares.

On February 15, 2017, just a month after publication of the Capital Group Letter, the SEC was compelled to issue guidance (the “FAQ”) addressing some of the questions it had received from mutual fund companies to-date.[v]  Below, we summarize FAQ as it relates to Funds seeking to implement Clean Shares.

Initial Implementation of Clean Shares

A mutual fund company issuing Clean Shares must, of course, amend its registration statement to include disclosure of the new share class.  Such an amendment might be affected through a Rule 485(a) filing or through a Rule 485(b) filing, depending on whether the amendment is “material”.[vi]  Typically, funds prefer Rule 485(b) filings because they become effective immediately,[vii] while Rule 485(a) filings are subject to a 60 day review.[viii]

In the FAQ, the SEC confirmed that “Funds should create these new Clean Shares, like any new class, by making a filing under Rule 485(a).”  To minimize the burdens of filing under Rule 485(a), if the only disclosures being amended are those describing the new share class, we advise mutual fund companies to seek selective review of the Rule 485(a) filing.  The request for a selective review should be made in the cover letter accompanying the 485(a) filing and must include (i) a statement as to whether the disclosure in the filing has been reviewed by the staff in another context; (ii) a statement identifying prior filings that the registrant considers similar to, or intends as precedent for, the current filing; (iii) a summary of the material changes made in the current filing from the previous filings; and (iv) any specific areas that the registrant believes warrant the SEC staff’s particular attention.[ix]

Adding Clean Shares to Multiple Funds

A mutual fund family adding Clean Shares to multiple funds need not file Rule 485(a) filings for each fund.  Instead, the FAQ confirms that mutual funds companies introducing Clean Shares across multiple funds can request Template Filing Relief pursuant to Rule 485(b)(i)(vii).  A registrant requesting Template Filing Relief would make a single Rule 485(a) filing with a Template Filing Relief request for all other funds with “substantially identical disclosure”.[x]

We note, however, that a request for Template Filing Relief must include (i) the reason for making the post-effective amendment; (ii) the identity of the Template filing;[xi] (iii) the identity of the registration statements that intend to rely on the relief (“Replicate filings”).[xii]  Additionally, the registrant must represent to the SEC that (i) the disclosure changes in the template filing are substantially identical to disclosure changes that will be made in the replicate filings; (ii) the replicate filings will incorporate changes made to the disclosure included in the Template filing to resolve any staff comments thereon; and (iii) the replicate filings will not include any other changes that would otherwise render them ineligible for filing under rule 485(b).[xiii]  Selective Review and Template Filing Relief can save registrants adding Clean Shares to existing funds time and money.

Existing Share Classes Qualify as Clean Shares

One of the more interesting aspects of the FAQ was the acknowledgement by the SEC that certain existing share classes of funds (such as institutional class shares) might already meet the requirements of Clean Shares, thereby offering a path to offering Clean Shares to many registrants without a Rule 485(a) filing.[xiv] In such a case, the SEC noted that a 485(a) filing would not be necessary “solely to add the prospectus disclosure described in the [Capital Group Letter]”[xv] where the fund already offers a share class that meets the requirements of the Capital Group Letter.[xvi]  Instead, a Rule 485(b) or Rule 497 filing will suffice.

Conclusion

The introduction of Clean Shares to the mutual fund industry presents an opportunity for mutual fund companies to improve the competitive position of their products, and we anticipate that there will be continued interest in Clean Shares even if the Department of Labor’s Conflict of Interest Rule does not become effective.[xvii]  If you have questions about Clean Shares of the SEC’s recent guidance, we encourage you to contact us.

 

[i] Andrew Sachs and John I. Sanders, Effects of the DOL Fiduciary Rule Reach Mutual Fund Industry, Kilpatrick Townsend: Investment Management News and Notes (Jan. 27, 2017), http://blogs.kilpatricktownsend.com/investmentmanagement/.

[ii] SEC, Response of the Office of Chief Counsel Division of Investment Management, available at https://www.sec.gov/divisions/investment/noaction/2017/capital-group-011117-22d.htm (“Capital Group Letter”).

[iii] Id.

[iv] John Waggoner, Brace for Thousands of New DOL Fiduciary-Friendly Mutual Fund Share Classes, INVESTMENT NEWS (Jan. 6, 2017), http://www.investmentnews.com/article/20170106/FREE/170109955/brace-for-thousands-of-new-dol-fiduciary-friendly-mutual-fund-share.

[v] SEC, Frequently Asked Questions on IM Guidance Update 2016-06 (Mutual Fund Fee Structures, available at https://www.sec.gov/divisions/investment/guidance/frequently-asked-questions-mutual-fund-fee-structures.htm (“FAQ”).

[vi] 17 CFR 230.485(a)-(b) (2017).

[vii] 17 CFR 230.485(b) (2017).

[viii] 17 CFR 230.485(a) (2017).

[ix] SEC: IM Guidance 2016-06, available at https://www.sec.gov.

[x] Id.

[xi] This identifying information should include the name of the Fund and the registrant, the Securities Act file number, and the filing date of the rule 485(a) filing.

[xii] This identifying information should include the name of the registrant, the Securities Act file number, and the series and class name for each of the Funds that intend to rely on the relief.

[xiii] SEC: IM Guidance 2016-06, available at https://www.sec.gov.

[xiv] FAQ, supra note 7.

[xv] Id. at Question 5.

[xvi] See, Capital Group Letter, supra note 2 (Listing the registrant’s representations to the SEC:  The broker will represent in its selling agreement with the fund’s underwriter that it is acting solely on an agency basis for the sale of Clean Shares; The Clean Shares sold by the broker will not include any form of distribution-related payment to the broker; The fund’s prospectus will disclose that an investor transacting in Clean Shares may be required to pay a commission to a broker, and if applicable, that shares of the fund are available in other share classes that have different fees and expenses; The nature and amount of the commissions and the times at which they would be collected would be determined by the broker consistent with the broker’s obligations under applicable law, including but not limited to applicable FINRA and Department of Labor rules; and Purchases and redemptions of Clean Shares will be made at net asset value established by the fund (before imposition of a commission).

[xvii] Paul Foley and John I. Sanders, Department of Labor Set to Eliminate the Fiduciary Rule, JD SUPRA (March 3, 2017), http://www.jdsupra.com/legalnews/department-of-labor-set-to-eliminate-92801/.

Posted on Friday, January 27 2017 at 10:34 am by

Effects of the DOL Fiduciary Rule Reach Mutual Fund Industry

By Andrew Sachs and John I. Sanders

The Department of Labor finalized the so-called “Fiduciary Rule” in April 2016 and announced it would go into effect in April 2017.[i]  Since the finalization of the Fiduciary Rule, the annuities,[ii] brokerage,[iii] and advisory industries[iv] have all seen substantial changes to products or fee structures.  Now, the effects of the rule have reached the mutual fund industry as well, with the SEC’s recent approval of American Funds’ “Clean Shares” – shares stripped of any front-end load, deferred sales charge, or other asset-based fee for sales or distribution that are sold by brokers who set their own commissions in connection with such sales.[v]

On January 11th, the SEC issued a no-action letter to Capital Group, the parent company of American Funds.[vi]  The no-action letter stated that the SEC concurred with Capital Group’s view that Section 22(d) of the Investment Company Act of 1940 (the “Act”), which prohibits selling securities except at “a current public offering price described in the prospectus,” does not apply to brokers when acting as agent on behalf of its customers and charging customers commissions for effecting transactions in Clean Shares.[vii]

At least one publication predicts that thousands of mutual funds will create similar classes of shares.[viii]  We believe that the ability to replace the distribution fees typically charged by its mutual funds with commissions charged by the broker will give funds a new measure of flexibility to meet the demands of the Fiduciary Rule and competition generally.  For those wishing to more fully understand the costs and benefits of adopting a similar share class, we are here to help.

Andrew Sachs is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem office. John I. Sanders is an associate in the firm’s Winston-Salem office.

 

[i] Department of Labor, Fact Sheet: Department of Labor Finalizes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle Class Families Billions of Dollars Every Year, https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/dol-final-rule-to-address-conflicts-of-interest.

[ii] Greg Iacurci, Insurers Developing Fee-Based Fixed-Index Annuities Post-DOL Fiduciary Rule, INVESTMENT NEWS (July 14, 2016), http://www.investmentnews.com/article/20160714/FREE/160719964/insurers-developing-fee-based-fixed-indexed-annuities-post-dol.

[iii] Katherine Chiglinsky and Margaret Collins, AIG CEO Blames Obama Retirement Rule for Broker-Dealer Exit, BLOOMBERG (Jan. 27, 2016), http://www.bloomberg.com/news/articles/2016-01-27/aig-broker-dealer-exit-fueled-by-obama-retirement-rule-ceo-says.

[iv] Darla Mercado, How the New “Fiduciary” Rule Will Actually Affect You, CNBC (Oct. 13, 2016), http://www.cnbc.com/2016/10/13/how-the-new-fiduciary-rule-will-actually-affect-you.html.

[v] John Waggoner, Brace for Thousands of New DOL Fiduciary-Friendly Mutual Fund Share Classes, INVESTMENT NEWS (Jan. 6, 2017), http://www.investmentnews.com/article/20170106/FREE/170109955/brace-for-thousands-of-new-dol-fiduciary-friendly-mutual-fund-share.

[vi] SEC, Response of the Office of Chief Counsel Division of Investment Management, available at https://www.sec.gov/divisions/investment/noaction/2017/capital-group-011117-22d.htm.

[vii] Id.

[viii] Waggoner, supra note 5.

Posted on Thursday, November 10 2016 at 2:03 pm by

Revised Form ADV: What CCOs Need to Know

By Paul Foley and John Sanders of Kilpatrick Townsend & Stockton

On Aug. 25, 2016, the Securities and Exchange Commission adopted final rules intended to update and enhance the disclosure requirements promulgated under the Investment Advisers Act of 1940—primarily by revising Form ADV. The final rules, which became effective on October 31, 2016 and have a compliance date of Oct. 1, 2017, are substantial and wide-ranging, and chief compliance officers should take note both of their provisions and the potential implementation issues they raise.

INCREASE IN SMA DISCLOSURES

Among the most significant amendments to Form ADV are those related to the disclosure of assets held in separately managed accounts. Advisers will now be required to disclose the approximate percentage of SMA assets that are invested in 12 broad asset categories, including exchange-traded equity securities, U.S. government bonds and derivatives.

This classification requirement presents a practical concern as certain SMA assets may not fit squarely within a single category. The SEC will allow advisers to use their own classification methodology for such assets, “so long as their methodologies are consistently applied and consistent with information the advisers report internally.” But what sounds like well-intentioned deference may not be as beneficial to advisers as it seems. In fact, it may trap unwary advisers, leaving them unable to change internal classification methodologies later.

Perhaps more surprisingly, the new SMA disclosure requirements may be of marginal utility with respect to SMAs holding significant interests in funds, such as exchange-traded funds, mutual funds, hedge funds and private equity funds. Indeed, despite the wide variations among fund asset allocations, the amendments only require advisers to disclose the amount of fund assets held in SMAs. Advisers are expressly told not to look through such funds with respect to the underlying exposure to the various asset categories.

The lack of a look-through mechanism means that the SEC and current and potential advisory clients may garner little information from the new disclosure requirements. This is particularly true with respect to advisers that primarily use funds in SMAs.

For example, if nearly all of an adviser’s SMA assets are invested in funds, the new disclosure requirements will provide almost no meaningful insight regarding the risk, diversification or strategies used by the adviser in SMAs. This issue will only grow more pronounced as advisers increasingly use ETFs and other fund-based strategies.

UMBRELLA REGISTRATION

Another noteworthy amendment to Form ADV tries to make umbrella registration more efficient. The SEC first allowed umbrella registration through no-action letter guidance in response to the new adviser registration requirements set forth in the Dodd-Frank Act. Today, around 743 filing advisers and 2,587 relying advisers are using umbrella registrations. The SEC believes this represents nearly all advisers entitled to use umbrella registration.

With umbrella registration already in extensive use, the true effect of these amendments is to codify the conditions that must be met before it can be employed. According to the SEC, this was done “to limit eligibility for umbrella registration to groups of private fund advisers that operate as a single advisory business.”

The Commission received a number of comment letters regarding umbrella registration that favored relaxing the requirements. Specifically, some objected to the condition that the filing adviser and relying advisers operate under a single code of ethics and a single set of written policies and procedures administered by a single CCO. But the SEC did not alter its position.

The agency’s focus on limiting the applicability of umbrella registration did not address a surprisingly popular practice whereby one or more advisers under common control, but organized as distinct entities, avoid registration entirely. In such circumstances, advisers specifically do not meet the requirements for umbrella registration and each adviser tries to rely on its own exemption from registration. This seems like a missed opportunity by the SEC to address a practice that one could argue is simply doing indirectly what is prohibited from being done directly.

SOCIAL MEDIA DISCLOSURE

Nestled among the amendments that will impact advisers immediately is one that, although somewhat significant today, will likely become even more important over time. Form ADV now requires disclosure of the adviser’s social media accounts and the address of each of the adviser’s social media pages. The SEC plans to use this information to prepare for examinations of advisers and compare information that advisers disseminate across different platforms.

We anticipate that SEC examiners will have heightened interest in advisers’ use of social media. Moreover, we believe this additional disclosure will lead to significantly more deficiencies and, potentially, enforcement related to the adviser recordkeeping and performance marketing rules.

CLARIFYING AMENDMENT AND TECHNICAL CHANGES

In addition to the changes discussed above, the SEC has made numerous amendments designed to clarify Form ADV and its instructions. Although the clarifying and technical amendments are too numerous to cover adequately here, an overview of the changes to Item 7, which the SEC revised significantly, provides an illustrative example.

Item 7.A., which requires advisers to disclose whether their related persons fall within certain financial industry categories, will now state that advisers need not disclose that some of their employees perform investment advisory functions or are registered representatives of a broker/dealer, since this information is reported elsewhere in Form ADV.

In a similar vein, Item 7.B asks whether an adviser serves as an adviser to a private fund and Section 7.B.(1) is where further information is provided. The SEC has added an explanation that Section 7.B.(1) of Schedule D should not be completed for a fund if another registered adviser or SEC-exempt reporting adviser reports the information. These amendments are likely to improve the overall quality of disclosure in Form ADV by making it more consistent among advisers.

BOOKS AND RECORD RULES

The SEC has also amended Rule 204-2, the books and records rule, under the Advisers Act. Rule 204-2(a)(16), which at present requires advisers to maintain records supporting performance claims in communications that are distributed to 10 or more persons, will now require records to be maintained for any performance claims distributed to any person.

In addition, Rule 204-2(a)(7) will now require advisers to maintain originals of all written communications received and copies of all written communications sent by an adviser relating to the performance or rate of return of any managed accounts or other securities recommendations. We believe these amendments to the books and records rule will have a limited impact on advisers because most advisers already maintain this information.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York office. John Sanders is an associate based in the firm’s Winston-Salem, North Carolina office.

Posted on Friday, October 14 2016 at 1:05 pm by

SEC Reports on Fiscal Year 2016 Enforcement Actions

On October 12, 2016, the Securities and Exchange Commission (the SEC), announced its enforcement results for the 2016 fiscal year.[1]  For all but the most dedicated followers of the SEC’s recent uptick in enforcement activities, the results are eye opening.

The Numbers

In 2016, the SEC filed a record 868 enforcement actions against a wide-range of actors.[2]  This represents a jump of over 7.5% from 2015 and 15% from 2014.[3]  The Wall Street Journal linked the record-breaking year to SEC Chair Mary Jo White’s “broken windows” strategy of pursuing “the smallest legal violations” as well as the serious, headline-grabbing frauds.[4]  The effect, Chair White says, “makes you feel like we are everywhere.”[5]

Not only was the SEC able to increase the number of enforcement actions filed in 2016, it also was successful in obtaining over $4 Billion in disgorgements and penalties through favorable orders, settlements, and judgements.[6]

Insider Trading

Several of the highlighted enforcement actions for the year involve a point of perpetual emphasis for the SEC: insider trading.[7]  In 2016, nearly 10% of all enforcement actions brought were related to insider trading.  Several of those stemmed from what the SEC described as “complex insider trading rings” uncovered through “innovative uses of data and analytics.”[8]

One illustration of a complex insider trading ring involves two hedge fund managers and a former government official.[9]  The former government official allegedly used deception, concealing his role as a hedge fund consultant, to obtain confidential information about upcoming approvals of generic drug applications from former colleagues at the Food and Drug Administration.[10]  The SEC alleged that one of the hedge fund managers made unlawful profits of nearly $32 million by insider trading on tips he received from the scheme.[11]

Investment Advisers

The SEC also revealed that investment advisers were a primary target of SEC enforcement actions in 2016.[12]  In fact, nearly 20% of enforcement actions brought during the year, were brought against investment advisers and investment companies.[13]  This was another SEC record.[14]

Those who have been following the SEC under Chair White are not surprised by the surge in enforcement actions against investment advisers.[15]  Chair White has moved examiners from the broker-dealer unit to the investment adviser unit of the Office of Compliance Inspections and Examinations in recent years.[16]  Chair White has directed the enlarged staff to examine issues that generate conflicts of interest, such as cybersecurity policies and financial incentives.[17]

In a special section of the press release, the SEC highlighted some of its enforcements actions against advisers.[18]  Among the highlights are eight actions related to private equity fund advisers.[19]  Some of the entities and individuals involved are giants in the private equity industry:  Blackstone Group,[20] Fenway Partners,[21] and WL Ross & Co.[22]  Each paid fines related to its failure to adequately disclose certain fee arrangements.

The SEC also brought an enforcement action against three AIG affiliates which earned fees for steering clients into share classes of mutual funds that charged 12b-1 fees when the clients were eligible for share classes that did not charge such fees. In a release announcing the settlement of those claims, the SEC warned that “investment advisers must be vigilant about conflicts of interest when selecting mutual fund share classes.”[23]  This mix of actions against investment advisers is an example of how the SEC’s broken windows approach creates the appearance of comprehensive enforcement.

New Tools

In reviewing the results of this record-setting year, industry participants should note what the SEC credits for its success. Chair Mary Jo White states that the SEC is “using new data analytics to uncover fraud, enhancing [the SEC’s] ability to litigate tough cases, and expanding the playbook bringing novel and significant actions to better protect investors and our markets.”[24]

Analytical technology is something that the SEC has been developing for several years.[25]  The Market Information Data Analytics System (MIDAS), introduced in 2013, gives the SEC greater ability to reconstruct market data time-stamped to the micro-second.[26]  Efforts to build the Consolidated Order Trail are still ongoing.[27]  However, once that is on-line, the SEC should become even better at selecting and winning enforcement actions.

Conclusion

It is understandable if securities professionals reading these results do, in fact, feel that the SEC is everywhere these days. These results should trigger a recommitment to regulatory compliance that includes doing the little things right.  We’re here to help.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. John Sanders is an associate in the firm’s Winston-Salem office.

[1] SEC, SEC Announces Enforcement Results for FY 2016 (Oct. 12, 2016), https://www.sec.gov/news/pressrelease/2016-212.html.

[2] Id.

[3] Jean Eaglesham, WALL ST. J., SEC Breaks Record for Number of Enforcement Cases (Oct. 11, 2016), http://www.wsj.com/articles/sec-on-track-to-break-record-for-number-of-enforcement-cases-1476198436.

[4] Id.

[5] Id.

[6] Id.

[7] Thomas O. Gorman, LEXIS NEXIS, Priorities for the SEC’s Enforcement Division (March 23, 2015), https://www.lexisnexis.com/legalnewsroom/securities/b/securities/archive/2015/03/23/priorities-for-the-sec-s-enforcement-division.aspx.

[8] SEC, supra note 1.

[9] Id.

[10] Jonathan Stempel, REUTERS, Visium’s Valvani Charged With Insider Trading (June 16, 2016), http://www.reuters.com/article/us-usa-fraud-insidertrading-idUSKCN0Z11TB.

[11] SEC, supra note 1.

[12] Id.

[13] Id.

[14] Eaglesham, supra note 3.

[15] Kenneth Corbin, FINANCIAL PLANNING, SEC Brings Record Number of Enforcement Actions Against Advisers (Oct. 12, 2016), http://www.financial-planning.com/news/sec-brings-record-number-of-enforcement-actions-against-advisers.

[16] Id.

[17] Id.

[18] SEC, supra note 1.

[19] Id.

[20] SEC, Blackstone Charged With Disclosure Failures (Oct. 7, 2015), https://www.sec.gov/news/pressrelease/2015-235.html.

[21] SEC, SEC Charges Private Equity Firm and Four Executives With Failing to Disclose Conflicts of Interest (Nov. 3, 2015), https://www.sec.gov/news/pressrelease/2015-250.html.

[22] CNBC, SEC Fines Wilbur Ross’ Firm $2.3 Million Over Fees (Aug. 25, 2016), http://www.cnbc.com/2016/08/25/sec-fines-wilbur-ross-firm-23-million-over-fees.html.

[23] SEC, AIG Affiliates Charged With Mutual Fund Shares Conflicts (March 14, 2016), https://www.sec.gov/news/pressrelease/2016-52.html.

[24] SEC, supra note 1.

[25] Elisse Walter, Chairman, SEC, Harnessing Tomorrow’s Technology for Today’s Investors and Markets (Feb. 19, 2013), https://www.sec.gov/News/Speech/Detail/Speech/1365171492300.

[26] SEC, MIDAS: Market Information Data Analytics System, https://www.sec.gov/marketstructure/midas.html.

[27] Rob Tricchinelli, BLOOMBERG BNA, SEC Releases Consolidated Audit Trail Plan (April 28, 2016), http://www.bna.com/sec-releases-consolidated-n57982070430/.

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