Category: SEC News

The timing of the Coronavirus is coming at the time most private funds are working on audited financial statements.

Form ADV and Form PF

The first move was giving some extra time to file your Form ADV. It requires notifying the SEC and posting information on your website. Similar extensions are available for filing Form PF.

Custody

The SEC updated Question II.1 of the Custody Rule FAQ about inadvertently receiving client funds or securities. Given that many firms are unable to access mail and deliveries at their offices, The SEC has revised the guidance to set the date when the firm is considered to have received such securities on the date that they actually are able to access mail or deliveries at their office locations. The guidance requires investment advisers to return inadvertently received client funds and securities. Now the FAQ modifies that the “three business day” clock begins to run when you have access to office mail and deliveries. This relief is only available when the investment adviser’s personnel are unable to access mail or deliveries as a result of the investment adviser’s business continuity plan relating to COVID-19.

Form ADV – Office Locations

With many firms operating under business continuity and working from home, I’ve heard some concerns about office locations. If people are working from home on a longer basis does that become an office location that needs to be reported on Form ADV?

The SEC stepped up and answered the question. ” As long as the employees are temporarily teleworking as part of the firm’s business continuity plan due to such circumstances, staff would not recommend enforcement action if the firm does not update either Item 1.F of Part 1A or Section 1.F of Schedule D in order to list the temporary teleworking addresses.”

Audited Financial Statements

There is an older FAQ on delivery of audited financial statements under the custody rule for pooled investment vehicles. What happens if you’re not able to get your audited financial statements out within the 120 days mandated by the custody rule?

A: The Division would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser that is relying on rule 206(4)-2(b)(4) and that reasonably believed that the pool’s audited financial statements would be distributed within the 120-day deadline, but failed to have them distributed in time under certain unforeseeable circumstances. (Question VI.g Modified March 5, 2010.)

I would put the Covid-19 into the category of unforeseeable circumstances. On the other hand, private fund documents typically contain a contractual obligation to deliver financial statements in a stated period of time.

Stay Healthy

I hope all the readers of Compliance Building are staying healthy. These are extraordinary times. Use common sense.

Sources:

• Order for Relief Related to Investment Advisers Act
• SEC Coronavirus (COVID-19) Response
• IARD and Form ADV FAQs
• Custody Rule FAQs

The Securities and Exchange Commission released its Fall Regulatory Flexibility Agenda, showing its expected rulemaking activity over the next year and updating the Spring edition of its agenda.

I highlighted three items from the Spring Agenda:

1. Amendments to the Marketing Rules
2. Amendments to the Custody Rules for Investment Companies and Investment Advisers
3. Harmonization of Exempt Offerings

The proposed amendments to the marketing rules came out two weeks ago. This puts is solidly in the proposed rule stage. The proposed new regulation is in the release.

Amendments to the Custody Rule is still on the Agenda. It seems to be generously designated as being in the “proposed rule stage.” Maybe I missed it, but I don’t remember seeing any proposed changes.

The Harmonization of Exempt offerings had a concept release this summer. It too is generously designated as being in the “proposed rule stage.”

What’s new that caught my eye?

Accredited Investor Definition. This gets a designation of “proposed rule stage.” I assume this will end up being a part of the harmonization of exempt offerings. But the SEC may end up treating this separately if the Commissioners have trouble coming to agreement on the larger harmonization. The agenda also lists Regulation Crowdfunding Amendments and Regulation A Amendments separately.

Amendments to the Whistleblower Program Rules are listed as being in the final rule stage. The proposed changes to the whistlebower program were published over a year ago in July 2018.

Sources:

• Agency Rule List – Fall 2019
• Looking Ahead to Regulatory Changes
• Proposed amendments to the marketing rules
• SEC Seeks Public Comment on Ways to Harmonize Private Securities Offering Exemptions
• Changes to the SEC’s Whistleblower Program

The Securities and Enforcement Commission’s Division of Enforcement release its 2019 Annual Report highlighting the 862 actions and $4.3 billion in disgorgement and penalties.

The report emphasized actions against individuals. Excluding the Share Class Initiative cases, 69% of the standalone cases were against individuals. This is in line with cases filed during the past few years. Included in this individual accountability is the suspension or barring of nearly 600 people from the securities industry.

Actions against investment advisers and investment companies in FY 2019 nearly doubled from the year before. That sounds ominous. But this increase includes 95 settlements that resulted from self-reports in the SEC’s Share Class Selection Disclosure initiative. Removing those cases, removes the over-allocation of cases to advisers.

For FY2019, the Division had __ ares of focus:

1. Retail investor protection, the most vulnerable to bad actors in the industry.
2. Cyber-related misconduct – hacking and ICO failures
3. Unlawful trading – new SEC tech to spot problems.

The Report highlights some of the Division’s difficulties.

The Kokesh case made it clear that the SEC’s power to impose penalties and disgorgement is subject to a five-year statute of limitations. The Report estimates that this has resulted in the SEC foregoing over $1 billion in disgorgement.

The SEC had been subject to a two-year hiring freeze, which was lifted in the Spring of 2019. The freeze is effectively a reduction in size because personnel leaving for retirements and departures can not be filed.

Sources:

• SEC’s Division of Enforcement 2019 Annual Report
• SEC highlights enforcement actions involving advisers and brokers
• Headwinds and Shifting Priorities: Beyond the Numbers in the SEC Enforcement Division’s 2019 Annual Report
• SEC Enforcement Division Reports on FY 2019
• Snapshot of a Cleaner Street: Another Landmark Year for Securities Enforcement

While I was preparing for Thanksgiving on Wednesday, the Securities and Exchange Commission put 43 of its rules on the chopping block.

As you know, it’s not so simple to just eliminate a rule. Eliminating a rule is itself a rulemaking, requiring notice and comment periods. Of course, the SEC would also need to justify why the rule which was at one time deemed to work, no longer works.

The Regulatory Flexibility Act requires requires federal agencies to review regulations for their impact on small businesses and consider less burdensome alternatives. Sec did its part and provided 43 rules. The list is not binding. It’s just notice that the SEC is thinking about making changes to these rules and invite comment. The rules may be continued without change, or could be
“amended or rescinded to minimize any significant economic impact of the rules upon a substantial number of such small entities.”

I’m not sure where private funds and real estate fund managers might fit into the size and scope of a “small entity.”

I found two rules to be the most applicable to private fund managers on the list:

1. 206(4)-8 Prohibition of fraud by advisers to certain pooled investment vehicles.
2. 206(4)-2 Custody Rule 

The applicability of fraud to investors rule is a bit a remnant from the SEC trying to breach the old small adviser exception to registration. There is always an inherent conflict between a fund manager looking out for the best interest of the fund and looking out for the best interest of a certain investor. Fund investors are going to have different tax, liquidity and diversity requirements. I’m not sure what is wrong with the rule that has caused the SEC to put it on this list.

The Custody Rule is full of land mines and foot faults for fund managers. I’m sure many fund managers and investment advisers would like clarification on many aspects of the rule and to clean up the messy guidance that has followed since the rule was last amended in 2009.

In a recent conversation with some SEC folks, we discussed the Chairman’s reminder that guidance is not binding. Word is that the SEC would like to roll up guidance into officially approved rules. It seems like the Custody Rule and its followup guidance fit into that category.

Sources:

• SEC Lists Rules for Review by Matt Kelly in Radical Compliance
• List of Rules to be Reviewed Pursuant to the Regulatory Flexibility Act Release Nos. 33-10576; 34-84640; 39-2523; IA-5067; IC-33298; File No. S7-25-18

The Securities and Exchange Commission has the same problem as any compliance professional: “How do you prove you’re being effective?”  The Enforcement Division issued its annual report of its ongoing efforts to protect investors and market integrity.

On one hand, remedying the identified harms committed by bad actors on investors is easy to measure. The missing piece is how effective the SEC was at identifying the bad actors. The second prong is a deterrence to the harmful conduct. What bad acts didn’t happen because the potential bad actor changed his mind?

Rightly, the report shows the quantitative and qualitative activities of enforcement.

The quantitative part is easy to lay out: 821 enforcement actions with $3.945 billion in disgorgement and penalties. That’s up from last year which had 754 actions yielding $3.7 billion.

Those are big numbers that should create some amount of deterrence. How much?

Co-Directors of Enforcement Stephanie Avakian and Steve Peiken de-emphasized the importance of those numbers and chose to focus on qualitative metrics such as “the nature, quality, and effects” of the Division’s enforcement program as a better measure of success. The report lays out five principles that guide the Enforcement Division’s assessment of its performance:

1. focus on the Main Street investor;
2. focus on individual accountability;
3. keep pace with technological change;
4. impose remedies that most effectively further enforcement goals; and
5. constantly assess the allocation of our resources.

As for the first item, the Annual Report highlights the Retail Strategy Task Force that was formed the past year.  The second is the Share Class Selection Disclosure Initiative. “We do not believe the Commission faces a binary choice between protecting Main Street and policing Wall Street. It must do both.”

For individual accountability, the Annual Report notes that firm does not act autonomously. People do the bad things. The enforcement actions were 70% charges against individuals.

We all are challenged with keeping pace with technological change. The Enforcement Division’s Cyber Unit became fully operational during the past year. The Annual Report has a focus on actions against cryptocurrency and ICOs.

The Enforcement Division wants to have a package of remedies to address misconduct. Besides the penalties and disgorgement, the SEC wants to tailor specific relief to address the misconduct. The report notes that the Kokesh decision limiting the periods eligible for disgorgement reduced the dollar amounts.

The SEC is still under an agency-wide hiring freeze that has been in place since late 2016. The Annual Report notes that the number of positions at the Enforcement Division, including the number of contractors supporting the it’s investigations, has decreased by 10% from FY 2016 to FY 2018.

Sources:

• Enforcement Division Annual Report – FY18
• U.S. SEC collects nearly $4 billion in fines, disgorgement in fiscal 2018 by Pete Schroeder
• SEC’s Division of Enforcement Issues 2018 Annual Report by Debevoise & Plimpton

 

On August 7, 2018, Elon Musk, the CEO of Tesla, tweeted to his 22 million Twitter followers that he could take Tesla private at $420 per share. There turned out to be little to no truth behind that public announcement. Regardless, Tesla’s stock price rose 6% on increased volume.

It took only a month and half for the SEC to bring its case against him. The SEC announced the filing of an enforcement action against Musk because:

Musk’s false and misleading public statements and omissions caused significant confusion and disruption in the market for Tesla’s stock and resulting harm to investors.

The SEC’s complaint alleges that Musk hadn’t discussed specific deal terms with any potential financing partners. He did have some discussions, but none about price.

“Taking care to provide truthful and accurate information is among a CEO’s most critical obligations.” – Stephanie Avakian, Co-Director of the SEC’s Enforcement Division.

It seems clear that Musk screwed up. It’s not clear that he did so for his own financial gain. If he had sold a bunch of stock right after the Tweet, it’s likely the Department of Justice would be involved and bringing criminal charges. The SEC complaint does ask for disgorgement and civil penalties. Elon has cash, so he can find the likely penalty in his couch cushions.

But the big claim for relief is to bar Musk from “acting as an officer or director of any issuer that has a class of securities registered pursuant to Section 12 of the Exchange Act or that is required to file reports pursuant to Section 15(d) of the Exchange Act.” That means no more CEO of Tesla.

There are few CEOs who are more closely identified with their companies that Musk and Tesla. We had Gates and Microsoft, and Jobs and Apple. I suppose Buffett and Berkshire-Hathaway are there.

I don’t know much about Tesla and don’t know if there is a bench of talent to fill in. The market doesn’t think so. The stock went down sharply after the charges were filed. It dropped 13% losing over $7 billion in shareholder value.

Just as quickly, Musk decided to settle with the SEC rather spend his time distracted by a lengthy battle. After all, there was no allegation of profit-making or conspiracy to manipulate. It was just a stupid off-the-cuff statement.  Rumor has it that Musk was close to settling last week, but pulled out and decided to fight. The market’s reaction over the weekend must have made him reconsider.

The SEC settled for Musk relinquishing his Chairman role, but he can stay on as CEO. The Chairman must be independent and the board must add two additional independent directors. That seems like some better corporate governance.

The SEC required a new committee of independent directors to put in place a additional controls and procedures to oversee Musk’s communications. On November 5, 2013, Tesla filed a Form 8-K disclosing that Musk’s Twitter account would be used to disseminate material information about the company.

To sum things up, the SEC imposed better governance on Tesla and pulled Musk’s Twitter privileges. That’s a good thing. The CEO should not have unfettered communication privileges with the public. You need accuracy and truth in corporate communication. Musk’s Twitter account was labeled as official corporate communication.

Sources:

• SEC Compliant Against Elon Musk
• Settlement Agreement
• Elon Musk Charged with Securities Fraud for Misleading Tweets
• Elon Musk Settles SEC Fraud Charges; Tesla Charged With and Resolves Securities Law Charge
• Tesla’s Biggest Dive Since 2013 Sends Musk an Urgent Message by Matt Robinson and Benjamin Bain
• The SEC/Musk/Tesla Settlement: The Dawning of a New Era of SEC Internet Enforcement by John Reed Stark
• Elon Musk to pay $20 million, step down as Tesla chair in SEC settlement

Yesterday, the Senate voted to confirm the nomination of Elad L. Roisman to be a member of the Securities and Exchange Commission. Mr. Roisman fills the vacant seat left by Michael Piwowar. This is the fourth Commissioner appointed by President Trump. I expect we will see pictures of the swearing in ceremony this morning.

Mr. Roisman was the chief counsel of the Senate Banking Committee. Before joining the Banking Committee, Roisman was counsel to former SEC Commissioner Daniel Gallagher.

Mr. Roisman will join Republican Commissioner Peirce and Chairman Clayton to likely bring a more de-regulatory stance to the agency

Commissioner Piwowar left the SEC in July and joined the Milken Institute on Wednesday.

The days of a full strength SEC may not last into 2019. Commissioner Stein is serving beyond her term and must step down at the end of the year. There seems to be little incentive for President Trump to speedily re-fill that Democratic spot.

If your wondering who the 15 Nay votes on the confirmation, they are the Senators you would expect.

NAYs —14
Baldwin (D-WI)
Blumenthal (D-CT)
Booker (D-NJ)
Durbin (D-IL)
Feinstein (D-CA)
Gillibrand (D-NY)
Harris (D-CA)
Markey (D-MA)
Menendez (D-NJ)
Merkley (D-OR)
Sanders (I-VT)
Schumer (D-NY)
Warren (D-MA)
Whitehouse (D-RI)

Sources:

• SEC Is Back at Full Strength With Five Members by Dave Michaels
• Senate Vote 202 on the nomination
• SEC Nominee Gets Hearing
• Nomination Hearing

Merrill Lynch has lots of relationships and is trying to manage an advisory business, a brokerage business and an investment banking business. It got into trouble for letting the last two interfere with the normal operations of its advisory business.

In general during the time of the SEC action, a material change in any product on Merrill’s advisory platforms, such as replacing the product’s portfolio manager, results in Merrill’s Due Diligence team conducting an in-depth review of the product. If they give it a thumbs down, the analysts put together a termination recommendation. It eventually ends up with Merrill’s Governance Committee for the ultimate decision. The Governance Committee had apparently always approved termination recommendations.

In 2012 one of the products in platform managed by a U.S. subsidiary of a foreign multinational bank announced a change in portfolio manager. It was a big change. The product was run by a single portfolio manager with accounts having a minimum of $100,000 invested in portfolios of 20-25 bonds specifically selected by the portfolio manager. The new manager was a team that had been responsible for institutional accounts with a minimum of $100 million invested in diversified portfolios of approximately 150 bonds.

That was a big change and had no track record for the new investing style. It seems like an easy termination and due diligence recommended the termination.

The problem is that a Merrill employee contacted the platform before the Governance Committee vote. The employee was trying to get in front of the operational issues from inevitable termination.

But that proactive communication gave the platform time to lobby Merrill management for a reconsideration. Apparently, that also included discussion of a possible active bookrunner role in a registered offering associated with the platform. Senior management apparently intervened in the termination process.

The most unusual part was the person who ran the agenda for Merrill’s Governance Committee got an email from a platform employee telling the Merrill person that the item was going to removed from the agenda.

The Due Diligence Employee received this email on the morning of January 16 and forwarded the email to another Merrill executive, stating, “Here is a first. An external manager telling an internal product staffer what can go on an internal governance agenda” to which the recipient responded, “[A]stonishing.”

The Governance Committee did not vote on the termination and instead diligence went back for more review.

Merrill ended up with non-active bookrunner rule in the offering, getting a smaller allocation.

Ultimately, the product stayed on hold for a year. The performance was satisfactory. It performed as well and in some instances better than the products that would have replaced it.

Investors were not harmed, but Merrill had a breakdown in procedure. It’s decision-making was clearly in conflict. The SEC came down hard, forcing Merrill to disgorge the fees it earned on the platform over the year and pay an equivalent fine.

Sources:

• Merrill Lynch Settles SEC Charges of Undisclosed Conflict in Advisory Decision
• SEC Order