Investment Management

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 Thursday, March 2 2017 at 3:13 pm by

Department of Labor Set to Eliminate the Fiduciary Rule

On March 2, 2017, the DOL proposed to extend the applicability date of the Department of Labor (“DOL”) Conflict of Interest Rule (the “Fiduciary Rule”) from April 10, 2017 for 60 days.[1]  The proposal states that the extension will make it possible for the DOL to take additional steps (e.g., propose rescission of the Fiduciary Rule) without the Fiduciary Rule becoming applicable.[2]  The DOL states that this approach is being taken so that “advisers, investors and other stakeholders would be spared the risk and expense of facing two major changes in regulatory environment.”[3]  This delay follows the Presidential Memorandum, sent by President Trump on February 3, 2017, that directed the DOL to examine whether the Fiduciary Rule would “adversely affect the ability of Americans to gain access to retirement information and financial advice.”[4]  Considering the language contained in the Presidential Memorandum and the text of DOL’s release, we do not believe the Fiduciary Rule is long for this world.

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] Id.

[4] Id.  The DOL was instructed to consider the following three questions in the course of its examination:  (1) whether the anticipated applicability of the final rule has harmed or is likely to harm investors due to a reduction of Americans’ access to certain retirement savings offerings, retirement product structures, retirement savings information, or related financial advice; (2) whether the anticipated applicability of the final rule has resulted in dislocations or disruptions within the retirement services industry that may adversely affect investors or retirees; and (3) whether the final rule is likely to cause an increase in litigation, and an increase in the prices that investors and retirees must pay to gain access to retirement services.  President Trump directed that if the DOL makes an affirmative determination as to any of the three inquiries or otherwise finds the Fiduciary Rule is incompatible with President Trump’s desire “to empower Americans to make their own financial decisions,” then the DOL is to publish for notice and comment rulemaking a proposal to revise or rescind the Fiduciary Rule.

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 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, 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/.

Posted on Friday, February 28 2014 at 9:32 pm by

SEC Provides No-Action Relief for M&A Brokers

On January 31, the staff of the Securities and Exchange Commission (“SEC”) issued a no-action letter (“No-Action Letter”) [1] permitting an “M&A Broker”, under certain circumstances, to facilitate mergers, acquisitions, business sales, and business combinations (together, “M&A Transactions”) in connection with the transfer of ownership of a “privately-held company” (any company that does not have any class of securities registered, or required to be registered, with the SEC under Section 12 of the Securities Exchange Act of 1934 and is not required to file periodic information, documents, or reports under Section 15(d) of the Exchange Act) without the M&A Broker registering as a broker-dealer under section 15(b) of the Exchange Act. The specific terms and conditions in the No-Action Letter are outlined below.

While the details of the definition of M&A Broker are complicated, the No-Action Letter has caught the securities industry by surprise. The No-Action Letter provides a potential exemption from SEC broker-dealer registration for many M&A industry consultants commonly referred to as “business brokers”, even if they are paid “finders” or “success” fees for securities-based M&A transactions between privately-held companies. In particular, the No-Action Letter permits an M&A Broker [2] to (i) advertise a privately-held company for sale with information such as the description of the business, general location, and price range, (ii) participate in the negotiations of the M&A Transaction, (iii) advise the parties to issue securities, or otherwise to effect the transfer of the business by means of securities, or assess the value of any securities sold, and (iv) receive transaction-based or other compensation, without registering as a broker-dealer with the SEC.

In particular, the SEC noted the following regarding M&A Brokers:

  • M&A Brokers may not have the ability to bind a party to an M&A Transaction.
  • M&A Brokers may not directly, or indirectly through any of its affiliates, provide financing for an M&A Transaction.
  • M&A Brokers may not have custody, control, or possession of or otherwise handle funds or securities issued or exchanged in connection with an M&A Transaction or other securities transaction for the account of others.
  • M&A Transactions may not involve a public offering, but instead must be conducted in compliance with an applicable exemption from registration under the Securities Act of 1933.
  • No party to any M&A Transaction may be a “shell company”,[3] other than a “business combination related shell company”.[4]
  • M&A Brokers representing both buyers and sellers must provide clear written disclosure as to the parties represented and obtain written consent from both parties to the joint representation. In addition, an M&A Broker facilitating an M&A Transaction with a group of buyers may do so only if the group is formed without the assistance of the M&A Broker.
  • The buyer, or group of buyers, in any M&A Transaction must, upon completion of the M&A Transaction, control and actively operate the company or the business conducted with the assets of the business.[5]
  • No M&A Transaction may result in the transfer of interests to a passive buyer or group of passive buyers.
  • Any securities received by the buyer or M&A Broker in an M&A Transaction will be restricted securities within the meaning of Rule 144(a)(3) under the Securities Act because the securities would have been issued in a transaction not involving a public offering.
  • M&A Brokers and each officer, director or employee of an M&A Broker: (i) cannot have been barred from association with a broker­dealer by the SEC, any state or any self-regulatory organization; and (ii) may not be suspended from association with a broker-dealer.

Future Considerations

The No-Action Letter is a welcome step towards clarifying the registration requirements for M&A Brokers; however, it remains to be seen what, if any, effect it will have on determinations under state securities laws and their varied definitions of “brokers”, “dealers” and “finders”. Although it is reasonable to assume that states that have adopted laws similar to federal law in this area may likewise adopt the interpretation presented in the No-Action Letter, only time will tell if this proves to be the case. We also recommend that individuals and companies looking to rely on the No-Action Letter to avoid SEC broker-dealer registration carefully consider the No-Action Letter’s requirements for transactions to fit under its parameters (namely, the requirements that qualifying transactions involve a buyer that will take voting control, assume executive officer or management positions or otherwise have the power to exert control over the seller after the transaction). Additionally, we note that the No-Action Letter does not address continuing issues regarding broker-dealer registration of private equity fund advisers that receive deal-based fees, who likely would not be able to comply with the M&A Broker definition. Nevertheless, the No-Action Letter’s stark departure from the SEC’s historical position that transaction-based compensation is the “hallmark of broker-dealer activity” is a positive step towards addressing, at the federal level, at least some of these issues.

For more information on the No-Action Letter, please contact any member of the Investment Management Team.


[1] SEC No-Action Letter re: M&A Brokers, dated January 31, 2014. A copy of the No-Action Letter is available here.

[2] An “M&A Broker” is defined in the No-Action Letter as a person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company (defined below) through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or its assets, whether through the power to elect officers and approve budgets or by service as an executive or other executive manager, among other things.

[3] A “shell” company is defined in the No-Action Letter as a company that: (1) has no or nominal operations; and (2) has: (i) no or nominal assets; (ii) assets consisting solely of cash and cash equivalents; or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets. In this context, a going concern need not be profitable, and could even be emerging from bankruptcy, so long as it has actually been conducting business, including soliciting or effecting business transactions or engaging in research and development activities.

[4] A “business combination related shell company” is defined in the No-Action Letter as a shell company (as defined in Rule 405 of the Securities Act) that is (1) formed by an entity that is not a shell company solely for the purpose of changing the corporate domicile of that entity solely within the United States or (2) formed by an entity defined in Securities Act Rule 165(f) among one or more entities other than the shell company, none of which is a shell company.

[5] A buyer, or group of buyers collectively, would have the necessary control if it has the power, directly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract, or otherwise. The necessary control will be presumed to exist if, upon completion of the transaction, the buyer or group of buyers has the right to vote 25% or more of a class of voting securities; has the power to sell or direct the sale of 25% or more of a class of voting securities; or in the case of a partnership or limited liability company, has the right to receive upon dissolution or has contributed 25% or more of the capital. In addition, the buyer, or group of buyers, must actively operate the company or the business conducted with the assets of the company.

 

 

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