Investment Management

Posted on Monday, November 27 2017 at 5:46 pm by

Another Shoe Drops: UBS Withdraws from the Broker Protocol

By Paul Foley, John I. Sanders, and Lauren Henderson

Only one month after Morgan Stanley withdrew from the Protocol for Broker Recruiting (the “Protocol”), a second major brokerage firm has announced its intention to withdraw effective December 1st. UBS says it is withdrawing as part of a strategy to focus on retaining its current brokers instead of recruiting brokers from competitors. [i] Still, many observers believe Morgan Stanley’s and UBS’s withdrawals are meant “to stanch the flow of brokers and client assets.”[ii] This flow, of course, has quickened in recent years as advisers have left traditional, large brokerage firms to form independent advisory firms.[iii]

When Morgan Stanley withdrew from the Protocol, many speculated as to whether the Protocol would survive.[iv] Such speculation has only increased as sources have confirmed that Morgan Stanley’s withdrawal was the catalyst for UBS’s departure.[v] We expect more firms are currently considering how to respond to two of the largest brokerage firms withdrawing from the Protocol, and we would not be surprised to see similar announcements before year-end.

If you have questions about the recent withdrawals from the Protocol or general questions about the complexities that arise in establishing an independent advisory firm, please feel free to contact us directly.

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

[i] Lisa Beilfuss, UBS to Pull Out of Pact on Broker Recruiting, WALL ST. J., Nov. 27, 2017, available at https://www.wsj.com/articles/ubs-to-pull-out-of-pact-on-broker-recruiting-1511799020 .

[ii] Id.

[iii] Neil Weinberg, Broker Protocol Reduced to a Sell Game, OnWallSteet, Oct. 18, 2016, available at https://www.onwallstreet.com/news/broker-protocol-reduced-to-a-shell-game.

[iv] Lisa Beilfuss, Morgan Stanley to Exit Accord on Broker Recruiting, WALL ST. J., Oct. 30, 2017, available at https://www.wsj.com/articles/morgan-stanley-to-exit-accord-on-broker-recruiting-1509380038

[v] Beilfuss, supra note 2.

Posted on Monday, October 30 2017 at 8:39 am by

Advisers Trading in Europe or Advising E.U. Clients Must Prepare for MiFID II

By Paul Foley, John I. Sanders, and Lauren Henderson

On January 3, 2018, the European Commission’s sweeping reform, the Markets in Financial Instruments Directive II (“MiFID II”), will become effective. MiFID II applies to firms providing investment services or performing investment activities in the European Union (the “E.U.”).[1] E.U. investment advisers, naturally, will be among those effected. However, U.S. investment advisers who transact in European financial markets or offer investment advice to E.U. citizens through separately managed accounts (“SMAs”), pooled products (e.g., hedge funds), or indirectly through sub-advisory arrangements may be effected as follows:

  • Trading Equities and Derivatives: Under MiFID II, equity trading must occur on regulated markets, multilateral trading facilities, systematic internalisers, or equivalent third country venues.[2] Accordingly, over-the-counter trading of European equities may be severely restricted and the cost of trading certain securities may increase substantially. In addition, derivatives are subject to new reporting requirements and national regulators are empowered to set position limits for certain derivatives.[3]
  • Marketing Separately Managed Accounts: Each U.S. investment adviser must review licensing requirements in each jurisdiction where an E.U. client or potential client resides to determine whether the adviser must establish a branch or obtain a license to do business in the jurisdiction.[4]
  • Marketing Pooled Products: U.S. investment advisers that offer alternative investment funds (“AIFs”) will be governed by the Alternative Investment Fund Managers Directive (“AIFMD”) and jurisdiction-specific private placement rules, not MiFID II, when engaging in marketing activities for an AIF.[5] Likewise, U.S. investment advisers offering Undertakings for Collective Investment in Transferable Securities (“UCITSs”) are not directly subject to MiFID II when marketing a UCITS to E.U. clients, but will be indirectly impacted by MiFID II’s investor protection regime.[6]
  • Providing Sub-Advisory Services to E.U. Firms: E.U. firms subject to MiFID II may attempt to delegate compliance obligations to U.S. investment advisers serving as their sub-advisors. Among compliance obligations likely to be passed to the U.S. sub-advisor are those related to transparency and reporting.[7]

We invite you to contact us directly if you have any questions about the application of MiFID II to U.S. investment advisers.

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

[1] Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on Markets in Financial Instruments and Amending Directive 2002/92/EC and Directive 2011/61/EU, 2014 O.J. (L 173) 349, 374.

[2] Id. at 409.

[3] Id. at 440, 444.

[4] Christopher D. Christian & Dick Frase, MiFID II: Key Considerations for US Asset Managers, 23 The Investment Lawyer. 1, 4 (May 2016).

[5] Id. at 5.

[6] Id.

[7] Id. at 4.

Posted on Tuesday, August 22 2017 at 2:05 pm by

Adviser Settles with SEC over Insider Trading Controls for Political Intelligence Firms

By Paul Foley and John I. Sanders

Yesterday, the SEC announced a settlement under which Deerfield Management Company L.P. (“Deerfield”), a hedge fund adviser, agreed to pay more than $4.6 million.[i]  The SEC charged Deerfield with failing to “establish, maintain and enforce policies and procedures reasonably designed to prevent the illegal use of inside information”[ii] as required by Section 204A of the Investment Advisers Act of 1940 (the “Advisers Act”).[iii]

The SEC cited Deerfield for failing to tailor its policies and procedures “to address the specific risks presented by its business.”[iv]  In particular, Deerfield’s reliance on third-party political intelligence firms to provide insight into upcoming legislative and regulatory action created the risk that Deerfield would receive and illegally trade on inside information (e.g., a regulator’s unannounced decision to finalize a rule that would materially affect certain industries and publicly traded companies).[v]

The SEC’s settlement with Deerfield serves as a warning for advisers utilizing investment strategies dependent on obtaining or correctly predicting non-public information (e.g., unannounced mergers and acquisitions or the governmental approval of a pharmaceutical product), particularly those advisers partnering with third party consultants and analysts.  Such advisers should consider whether their current policies and procedures address the specific risks likely to arise under such strategies and partnerships.

Please contact us if you have any questions about the SEC’s recent settlement with Deerfield or an adviser’s obligations under the Advisers Act generally.

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.

[i] SEC, Hedge Fund Adviser Charged for Inadequate Controls to Prevent Insider Trading (Aug. 21, 2017), available at https://www.sec.gov/news/press-release/2017-146 (hereinafter SEC Release).

[ii] Id.

[iii] 15 USC 80b-4a (2017).

[iv] SEC Release, supra note 1.

[v] Id.

Posted on Thursday, August 17 2017 at 8:39 am by

DOL Proposes an Extension of the Fiduciary Rule Transition Period

By Paul Foley and John I. Sanders

When the DOL Fiduciary Rule became effective on June 9th, it marked the start of a transition period that was scheduled to end on January 1, 2018 (the “Transition Period”).[i]  During the Transition Period, compliance burdens under the Fiduciary Rule are relaxed.  For example, those seeking to rely on the Best Interest Contract Exemption (the “BIC Exemption”) will face less stringent requirements.[ii]  Also, the DOL stated that it would not bring enforcement actions during the Transition Period against “fiduciaries who are working diligently and in good faith to comply with the new rule and exemptions.”[iii]

Last week, the DOL submitted proposed amendments to the BIC Exemption and certain other exemptions to the Fiduciary Rule.[iv]  We learned of this development through a 2-page filing the DOL made in relation to ongoing litigation.[v]  Unfortunately, the filing provided little detail, and the full text of the proposed amendments will not be available to the public until the conclusion of an interagency review.[vi]  However, what seems apparent, based upon the title of the proposed amendments in the filing, is that the proposed amendments include an extension of the Transition Period from January 1, 2018 to July 1, 2019.[vii]

In the long term, we believe that the DOL’s proposed amendments foreshadow either significant modifications to or a full repeal of the Fiduciary Rule and its exemptions.  In the near term, we believe the extension of the Transition Period, coupled with the temporary non-enforcement policy, provides fiduciaries with a reason to breathe easier.

Please contact us if you have any questions about this article or the DOL Fiduciary Rule generally.

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.

[i] 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-1.pdf.

[ii] Id.

[iii] Id.

[iv] Thrivent Financial for Lutherans v. Acosta, et al., No. 0:16-cv-03289 (D. Minn. Sept. 29, 2016), available at http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&uact=8&ved=0ahUKEwjTqJP_utzVAhWI7CYKHdKTDrcQFggrMAE&url=http%3A%2F%2Fmedia.thinkadvisor.com%2Fthinkadvisor%2Farticle%2F2017%2F08%2F09%2Fthriventvdolnotice8-9-2017.pdf&usg=AFQjCNFWeSsTSR6C69Z17yHF1q1a7bkDpg.

[v] Id.

[vi] Id.

[vii] Id.

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 Wednesday, April 5 2017 at 11:50 am by

SEC Issues Custody Rule Guidance

By Paul Foley and John I. Sanders

In February, the Securities and Exchange Commission (SEC) issued two significant pieces of guidance on arrangements that may result in an investment adviser having “custody” of its client assets as that term is defined in Rule 206(4)-2 (Custody Rule)[1] of the Investment Advisers Act of 1940 (Advisers Act).[2] The first piece of guidance was a Guidance Update issued by the SEC’s Division of Investment Management. The second came in the form of a no-action letter (Letter) issued to the Investment Adviser Association (IAA) on February 21, 2017. This article discusses both and offers practical insight into compliance with the Custody Rule.

Background

Under the Custody Rule, an investment adviser is deemed to have custody of client assets when it or a related person “holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services” it provides to its clients.[3] Additionally, the term custody includes any arrangement under which an investment adviser is “authorized or permitted to withdraw client funds or securities maintained with a custodian upon [its] instruction to the custodian.”[4] When an investment adviser is deemed to have “custody,” a number of regulatory requirements are triggered, including an independent verification by an accountant (a “surprise examination”).[5] Accordingly, investment advisers must understand when they have custody of client assets. The SEC’s recent guidance addresses instances in which investment advisers may not know that they have custody and, therefore, are subject to the various regulatory requirements of the Custody Rule.

Guidance Update

An IM Guidance Update published by the SEC’s Division of Investment Management stated that investment advisers may “inadvertently have custody of client funds or securities because of provisions in a separate custodial agreement entered into between its advisory client and a qualified custodian.”[6] The Division of Investment Management found that some custodial agreements grant an adviser the broad power “to instruct the custodian to disburse, or transfer, funds or securities.”[7] Where the adviser has that power, it may be deemed to have custody of the assets even though it did not intend to have such power and its contractual agreement with the client directly prohibits it from taking such action.[8]

The Division of Investment Management found that inadvertent custody arose from some commonly observed custodial agreement provisions:[9]

  • A custodial agreement that grants the client’s adviser the right to “receive money, securities, and property of every kind and dispose of same.”
  • A custodial agreement under which a custodian may rely on the “[adviser’s] instructions without any direction” from the client and asks the client to “ratify and confirm any and all transactions with [the custodian]” made by the adviser.
  • A custodial agreement that provides authorization for the client’s adviser to “instruct us to disburse cash from your cash account for any purpose . . . .”

After describing how advisers might have inadvertent custody of client assets, the SEC cautioned that rectifying inadvertent custody could not be accomplished through a bilateral agreement between the adviser and the client as the custody stems from the custodian’s perception of the adviser’s power.[10] The adviser can alter that perception by: (i) delivering a letter to the custodian that limits the adviser’s authority to “delivery versus payment” notwithstanding a greater grant of power in the custodial agreement; and (ii) obtaining written acknowledgement of the limitation from the client and custodian.[11]

After providing common custodial agreement provisions that may create inadvertent custody, the Guidance Update specified one common provision which does not, in itself, create custody. The SEC stated that where a custodial agreement permits merely the deduction of advisory fees, “an adviser may have custody but not need a surprise examination, provided it otherwise complies with the exception under Rule 206(4)-2(b)(3) available to advisers with limited custody due to fee deduction.”[12] A broader grant of power, however, likely constitutes custody.

We believe the Guidance Update may place a substantial burden on investment advisers. It will not be enough for investment advisers to review their own advisory agreements and other form documents. Instead, an adviser must work with all custodians holding its clients’ assets to obtain and examine any custodial agreement provisions that might create inadvertent custody for the adviser. Moreover, the adviser would need to monitor those agreements for material changes in perpetuity. Of course, the simpler, but still burdensome, path to compliance may be to send letters to all clients and their custodians and obtain their acknowledgement of the adviser’s limited power as a preventative measure.

The IAA No-Action Letter

Dovetailing the Guidance Update, in a letter dated February 15, 2017, the IAA asked the SEC staff to clarify that an investment adviser does not have custody under the Custody Rule “if it acts pursuant to a standing letter of instruction or other similar asset transfer authorization arrangement established by a client with a qualified custodian.”[13] In the alternative, the IAA asked the SEC to state it would not recommend an enforcement action under Section 206(4) of the Act and the Custody Rule against an investment adviser acting pursuant to a standing letter of authorization (SLOA), as described in the Letter, without obtaining a surprise examination of the custodied assets as required by the Custody Rule.[14]

The IAA stated that it is common for an advisory client to grant its registered investment adviser the power, through a SLOA, to disburse funds to specifically-designated third parties. Granting such power to an investment adviser is especially helpful where the client owns multiple accounts with different purposes across multiple custodians. Under such an arrangement, the client grants authority to the adviser, then the client instructs the custodian to transfer assets to the designated third parties on the adviser’s command. After issuing a SLOA, the client retains the power to change or revoke the arrangement, and the adviser’s authority is limited by the specific terms of the SLOA.[15] It was the IAA’s positon that such an arrangement did not constitute custody.[16]

The SEC determined that a SLOA, as described by the IAA may, in fact, lead to an investment adviser having custody of its client assets as contemplated by the Custody Rule. The general rule, as articulated by the SEC, is that an “investment adviser with the power to dispose of client funds or securities for any purpose other than authorized trading has access to the client’s assets” and thus has custody of those assets.[17] Because the SLOA or other similar authorization would permit the investment adviser “to withdraw client funds or securities maintained with a qualified custodian upon its instruction,” an investment adviser entering into an SLOA or similar arrangement would have custody of client assets and would be required to comply with the Custody Rule.

The SEC then stated that it would not recommend enforcement action under Section 206(4) of the Adviser Act or the Custody Rule against an investment adviser that enters into a SLOA that meets the following requirements and does not obtain a surprise examination:[18]

  1. The client provides an instruction to the qualified custodian, in writing, that includes the client’s signature, the third-party’s name, and either the third-party’s address or the third-party’s account number at a custodian to which the transfer should be directed.
  2. The client authorizes the investment adviser, in writing, either on the qualified custodian’s form or separately, to direct transfers to the third party either on a specified schedule or from time to time.
  3. The client’s qualified custodian performs appropriate verification of the instruction, such as a signature review or other method to verify the client’s authorization, and provides a transfer of funds notice to the client promptly after each transfer.
  4. The client has the ability to terminate or change the instruction to the client’s qualified custodian.
  5. The investment adviser has no authority or ability to designate or change the identity of the third party, the address, or any other information about the third party contained in the client’s instruction.
  6. The investment adviser maintains records showing that the third party is not a related party of the investment adviser or located at the same address as the investment adviser.
  7. The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

We believe few SLOAs or similar arrangements currently in place would satisfy these extensive requirements. The SEC seems to agree. It noted that investments advisers, qualified custodians, and their clients would need “a reasonable period of time” to comply with the relief provided by the no-action letter.[19] Further, the SEC stated that any investment adviser that is party to a SLOA that results in custody would not need to include the affected client assets in its response to Item 9 of Form ADV until the next annual updating amendment after October 1, 2017.[20]

The Letter, on its face, could be construed broadly to cover a number of common arrangements. However, the Letter was limited by a SEC statement published the same day.[21] In that statement, the SEC explained that the limited authority to transfer assets between accounts, whether with the same custodian or different custodian, provided that the client has authorized the adviser to make the transfers between specified accounts and has provided the custodians a copy of the authorization, does not constitute custody.[22] The SEC also noted that an adviser’s ability to transfer client assets between accounts at the same custodian or between affiliated custodians that have access to both account numbers and client account name does not amount to custody.[23] Therefore, the Letter seems to directly affect only SLOAs and similar arrangements under which the adviser has the authority to withdraw and disburse clients assets.

Despite the limiting effect of the SEC’s statement, advisers who are currently parties to a SLOA or similar arrangement should carefully review the terms of those arrangements. Where the arrangements do not meet the seven conditions for relief stated in the Letter, the adviser should work to either: (i) change the terms of the arrangement; or (ii) comply with the terms of the Custody Rule and disclose those assets in the next annual amendment to Form ADV after October 1, 2017.

Conclusion

The SEC’s recent guidance may generate significant anxiety among investment advisers concerned about becoming subject to the requirements of the Custody Rule. In particular, the SEC’s recent guidance raises the specter of custody arising from longstanding SLOA arrangements or even from contracts the investment advisers have not seen or do not regularly review. Please feel free to contact us with any questions you may have.

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.

13776971v.4

[1] 17 CFR 275.206(4)-2 (2017).

[2] 15 USC 80b et al (2017).

[3] 17 CFR 275.206(4)-2(d)(2) (2017).

[4] 17 CFR 275.206(4)-2(d)(2)(ii) (2017).

[5] 17 CFR 275.206(4)-2 (2017). Under the Custody Rule, among other things, an investment adviser must: maintain client funds and securities with a “qualified custodian” either under the client’s name or under the investment adviser’s name as agent or trustee for the client; notify its clients promptly upon opening a custodial account on their behalf and when there are changes to the information required in the notification; and have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements directly to the client.

[6] SEC, IM Guidance Update: Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority (Feb. 2017), available at www.sec.gov.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

[11] Id.

[12] Id.

[13] SEC, Investment Advisers Act of 1940 – Section 206(4) and Rule 206(4)-2; Response to the Investment Adviser Association (Feb. 21, 2017), available at https://www.sec.gov/divisions/investment/noaction/2017/investment-adviser-association-022117-206-4.htm.

[14] Id.

[15] Id.

[16] Id.

[17] Id.

[18] Id.

[19] Id.

[20] Id.

[21] SEC, Staff Responses to Questions About the Custody Rule (Feb. 21, 2017), available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.

[22] Id.

[23] Id.

Posted on Tuesday, January 24 2017 at 3:08 pm by

Constitutionality of SEC Judges Questioned

By Paul Foley and John I. Sanders

Among the many provisions of the Dodd-Frank Act were some that gave the SEC greater ability to hear cases and levy punishments in internal administrative courts without resort to ordinary federal courts.[i]  These provisions resulted in alarming results, including a 90% success rate for the SEC in front of its own newly-minted administrative law judges.[ii]  For comparative purposes, the SEC’s previous success rate was below 70%.[iii]

A legal challenge brought against the SEC argued that these judges are “inferior officers” that, pursuant to the Appointments Clause of the U.S. Constitution,[iv] must be appointed by an executive branch member and approved by the Senate.  Because such steps were never taken, the judges’ actions would be unconstitutional if they are, in fact, found to be “inferior officers”.  The 10th Circuit has agreed with the plaintiffs, but the SEC is expected to appeal.[v]

If the challenge is ultimately successful, there will be two significant impacts.  First, the cases decided by the SEC’s judges may be void.  Second, the SEC will be forced to use the old, less certain procedure of bringing enforcement actions in federal district court.  If you’d like to know more, I encourage you to read a succinct review of the matter in today’s Wall Street Journal.[vi]

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 in the firm’s Winston-Salem office.

[i] Giles D. Beal IV, Judge, Jury, and Executioner:  SEC Administrative Law Judges Post-Dodd Frank, 20 N.C. Banking Inst. 413 (2016), available at https://litigation-essentials.lexisnexis.com/webcd/app?action=DocumentDisplay&crawlid=1&doctype=cite&docid=20+N.C.+Banking+Inst.+413&srctype=smi&srcid=3B15&key=e7ef73edd6e64a6ec56e122360340a35.

[ii] Jean Eaglesham, SEC Wins with In-House Judges, Wall St. Journal (May 6, 2015), http://www.wsj.com/articles/sec-wins-with-in-house-judges-1430965803.

[iii] Id.

[iv] U.S. Const. art. II, sec. 2, cl. 2.

[v] Alison Frankel, 10th Circuit Strikes Down SEC ALJ Regime, Debates Reach to Other Agencies, Reuters (Dec. 28, 2016), http://www.reuters.com/article/otc-sec-idUSKBN14H1S3.

[vi] David B. Rivkin Jr. and Andrew M. Grossman, When is a Judge Not Really a Judge?, Wall St. Journal (Jan. 23, 2017), http://www.wsj.com/articles/when-is-a-judge-not-really-a-judge-1485215998.

Posted on Thursday, December 15 2016 at 9:28 am by

Supreme Court Confirms Expansive View of Insider Trading

By Paul Foley, Clay Wheeler, and John Sanders

Perhaps the most serious charge that could be leveled against a reader of this blog is that of being engaged in or associated with “insider trading.”  The allegation alone is enough to derail or end a promising career.  Successful compliance requires an understanding of the law and your obligations under it.  In light of recent developments regarding insider trading, including the first Supreme Court decision to address the crime in 20 years,[1] we encourage you to read this article in its entirety and contact us with any questions you may have.

Insider Trading:  The Tradition

Section 10(b) of the Securities Exchange Act of 1934[2] and Rule 10b-5[3] promulgated thereunder prohibit insider trading.  The basic elements of insider trading are:  (i) engaging in a securities transaction, (ii) while in possession of material, non-public information, (iii) in violation of a duty to refrain from doing so.

The paradigm case discussing the so-called “classical” theory of insider trading is Chiarella v. U.S.[4]  In Chiarella, an employee of a publishing firm was charged with insider trading after using advance notice of a takeover bid to trade.  Chiarella’s conviction was reversed by the Supreme Court after the Court focused on the requirement of a duty running from the trader to the shareholders of the corporate entity “owning” the material, non-public information.  Thus, a successful prosecution under the classical theory usually involves a corporate insider trading in shares of his or her employer while in possession of material, non-public information (e.g., advance notice of a merger).

After Chiarella, an important development in the law has been the extension of liability to persons who receive tips from insiders, i.e., individuals whose duty to refrain from trading is derived or inherited from the corporate insider’s duty.  Thus, not only may insiders be liable for insider trading under rule 10b-5, but those to whom they pass tips, either directly (tippees) or through others (remote tippees) may be liable if they trade on such tips.  Because tippee and remote tippee liability is more difficult to grasp and more likely to affect our readers, this article will primarily, but not exclusively, focus on individuals in those circumstances.

In a pattern that has repeated itself over the years, courts broadened the scope of insider trading by developing a second, “complementary”[5] theory of insider trading – the “misappropriation” theory.  This theory “targets person[s] who are not corporate insiders but to whom material non-public information has been entrusted in confidence and who breach a fiduciary duty to the source of the information to gain personal profit in the securities market.”[6]  The seminal case in the articulation of the misappropriation theory is U.S. v. O’Hagan.  In O’Hagan, a partner at a large law firm (but not ours) obtained and traded on information given to attorneys in the firm who were representing a client in a tender offer.  The Supreme Court held that “A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, may be held liable for violating § 10(b) and Rule 10b-5.”[7]  In practical terms, under the misappropriation theory, individuals who come into possession of material, non-public information while providing services to corporate clients, such as the attorney in O’Hagan [8] may be held liable.

Joining Chiarella and O’Hagan in making up the traditional core of insider trading law is Dirks v. SEC.[9]  In Dirks, the Supreme Court attempted to set a limit on the scope of insider trading.[10]  Dirks was a securities analyst who learned from a former insurance company insider that the company was committing fraud and was on the verge of financial ruin.[11]  Dirks investigated and disclosed this information to several people, including a reporter and clients who traded on the information.[12]  Dirks was held liable for insider trading, but appealed.[13]  The overturning of Dirks’s liability centered on the fact that the corporate insider had disclosed the fraud to Dirks purely by a desire to expose the fraud, rather than to obtain any financial or other personal benefit.  The Court held:

In determining whether a tippee is under an obligation to disclose or abstain, it is necessary to determine whether the insider’s “tip” constituted a breach of the insider’s fiduciary duty.  Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure.  Absent an improper purpose, there is no breach of duty to stockholders.  And absent a breach by the insider, there is no derivative breach.[14]

Furthermore, Dirks introduced the idea that a tippee has to be actually aware of the tipper’s breach or presented with sufficient facts so that the tippee will be deemed aware.  In this way, Dirks created a “personal benefit” element related to the tipper.  After Dirks, prosecutors were generally confident they could prove this benefit existed as long as there was a quid pro quo or a moderately close relationship between tipper and tippee.

Newman:  A Disruption

Chiarella, O’Hagan, and Dirks guided the law of insider trading largely uninterrupted for nearly 20 years.  Then came a decision from the Second Circuit, the so-called “Mother Court”[15] of securities law, but an underling of the Supreme Court, called U.S. v. Newman.[16]

Newman involved a hedge fund portfolio manager who was part of an information-sharing cohort of analysts and portfolio managers.[17]  By the time Newman received the tip, he was “four levels removed from the insider tippers,” (i.e., a remote tippee).[18]  The tippers were insiders at technology companies who had provided information to what the court termed “casual acquaintances,” who in turn passed those tips on.  Citing Dirks repeatedly for support, the U.S. 2nd Circuit Court of Appeals emphasized that government must prove the tipper received “a personal benefit” and that the tippee knew of that benefit.[19]

In Newman, the Second Circuit concluded that “the mere fact of friendship” was insufficient to give rise to the required personal benefit to the tipper.  Instead, the court required “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”  Despite the fact that the 2nd Circuit cited its adherence to Dirks in overturning Newman’s conviction, it was clear to all that by raising the bar for the evidence required to meet the Dirks “personal benefit” requirement, the opinion suggested a serious new limitation on insider trading law.  Moreover, the prosecutors were denied a rehearing en banc and a Supreme Court writ of certiorari.  This meant Newman would remain law in the most significant federal circuit for securities law until further notice.

One attorney called Newman “a well-deserved generational setback for the Government.”[20]  The predicted effect of Newman was that the government would be forced to prove that someone charged with insider trading knew that she was trading on non-public, material information and that “the tipper’s goal in disclosing information is to obtain money, property, or something of tangible value.”[21]  This heightened burden led to the reversal of more than a dozen insider trading convictions,[22] and pending cases were dropped.[23]

Salman:  The Expansive View of Insider Trading Strikes Back

Newman’s holding concerning what qualifies as a personal benefit to the tipper was reversed last week when the Supreme Court issued its opinion in Salman v. United States.[24]  Before the Supreme Court issued its opinion, in Salman, only the most ardent securities law gurus followed the case.  So, some background may be helpful.  Salman was convicted after trading on material, non-public information received from a friend, who had received the information from Salman’s brother-in-law.  Thus, Salman was prosecuted as a remote tippee.  He argued that he could not “be held liable as a tippee because the tipper (his brother-in-law, who worked on M&A matters at an investment bank) did not personally receive money or property in exchange for the tips.”[25]

In a strong rebuke, the Supreme Court held, “To the extent that the Second Circuit in Newman held that the tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to a trading relative, that rule is inconsistent with Dirks.[26]  Justice Alito succinctly explained “a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty” and that duty is breached “when the tipper discloses the inside information for a personal benefit.”[27]  Such a personal benefit can be inferred where the tip is made “to a trading relative or friend.”[28]

Why Salman Matters

By allowing a generous inference of a benefit to the tipper based on a personal relationship alone, the Supreme Court in Salman reestablished the old order of things – an expansive scope for insider trading prosecutions.  We understand that investment advisers are more likely than others to come into contact with corporate insiders, as well as those with whom corporate insiders speak in confidence.  You know these individuals as professionals, former schoolmates, and even friends and family members.  In discussing your work, it is quite possible that non-public, material information may be intentionally or inadvertently tipped to you.  Your livelihood and liberty may depend on how well you understand your legal obligations when that happens.  Fortunately, when you have questions about the rules regarding insider trading, we’re here to assist.

 

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

 

[1] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[2] 15 U.S.C. 78j (2016).

[3] 17 CFR 270.10b-5 (2016).

[4] Chiarella v. U.S., 445 U.S. 222 (1980).

[5] U.S. v. O’Hagan, 521 U.S. 642, 643 (1997).

[6] SEC v. Obus, 693 F.3d 276, 284 (2d Cir. 2012).

[7] O’Hagan, at 642.

[8] Id.

[9] Dirks v. SEC, 463 U.S. 646 (1983).

[10] Id. at 646.

[11] Id.

[12] Id.

[13] Id.

[14] Id. at 647.

[15] James D. Zirin, American Bar Association, The Mother Court: A.K.A., the Southern District Court of New York, http://www.americanbar.org/publications/tyl/topics/legal-history/the-mother-court-aka-southern-district-court-new-york.html

[16] U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014)

[17] Id. at 443.

[18] Id.

[19] Id. at 450.

[20] Jon Eisenberg, How the United States v. Newman Changes the Law, Harvard Law School Forum on Corporate Governance and Financial Regulation (May 3, 2015), https://corpgov.law.harvard.edu/2015/05/03/how-united-states-v-newman-changes-the-law/.

[21] Salman v. U.S., available at https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwihloXYvu_QAhVBjpAKHflsCIIQFggjMAE&url=https%3A%2F%2Fwww.supremecourt.gov%2Fopinions%2F16pdf%2F15-628_m6ho.pdf&usg=AFQjCNGY28IXIk-a-h-Nuvi5EXSHC6XW6g&sig2=Ydo5oy44CzIMDuCxjMluzA&bvm=bv.141320020,d.eWE (The opinion presents and rejects this argument from Salman before stating that the rule from Newman is inconsistent with precedent)

[22] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[23] Patricia Hurtado, SAC Capital’s Steinberg Gets Insider Trading Charges Dropped, Bloomberg (Oct. 23, 2015), https://www.bloomberg.com/news/articles/2015-10-22/u-s-drops-charges-against-sac-capital-s-michael-steinberg.

[24] Salman, supra note 21.

[25] Id.

[26] Id.

[27] Id.

[28] Id.