Category: SEC News

Compliance Outreach Program National Seminar 2018

I didn’t manage to get down to Washington DC to be there in person, but I’ve been watching the webcast of the Compliance Outreach Program National Seminar 2018 For Investment Adviser and Investment Company Senior Officers this morning.

This is the agenda and my notes so far.

Introductory Remarks from SEC Directors
Speakers:

  • Dalia Blass, Director, Division of Investment Management
  • Peter Driscoll, Director, Office of Compliance Inspections and Examinations (National Exam Program)
  • Stephanie Avakian, Co-Director, Division of Enforcement

Good policy starts with good information. To get the information you need to interact with others. The SEC wants to engage with compliance professionals to get better information to be able to make better policies.

They wanted to avoid CCO liability, but it was one of the most asked question.

One category are cases where the CCO was actively involved in the malfeasance or engaged in misleading regulators. This is the biggest category.

The second is where the CCO had a clear responsibility to implement a procedure and failed to.

There is a new alert coming out later today on fees and expenses. (Here it is:  Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers (PDF))

Insights from SEC Leadership Regarding Program Priorities
Speakers:

  • Paul Cellupica, Deputy Director, Division of Investment Management
  • C. Dabney O’Riordan, Co-Chief, Division of Enforcement, Asset Management Unit, Los Angeles Regional Office
  • Kristin Snyder, Co-National Associate Director, National Exam Program, San Francisco Regional Office

Update on certain National Exam Initiatives
Fiscal year 2018 priorities
Update on certain fiscal year 2017 priorities

A sunshine act notice went out for a meeting on April 18. There is a continuing effort to avoid investor confusion between the different type of financial firms. The subject matters of the Open Meeting will be the Commission’s consideration of:

  • whether to propose new and amended rules and forms to require registered investment advisers and registered broker-dealers to provide a brief relationship summary to retail investors.
  • whether to propose a rule to establish a standard of conduct for broker-dealers and natural persons who are associated persons of a broker-dealer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.
  • whether to propose a Commission interpretation of the standard of conduct for investment advisers.

The SEC will focus on ETFs. All of them are operating on exemptive orders. It makes sense to standarize the platforms instead of ad hoc rulings.

The Volker Rule is still alive and the SEC is going to keep working on it. But it sounds like the SEC wants to simplify it and remove some of the compliance burdens. Given the number of agencies involved, the SEC is just one player.

Fair Act is being considered regarding reports on various companies and wants to extend it to investment companies.

The SEC is considering a revamp of the marketing rules for investment advisers. There will be a particular focus on the anti-testimonial rule and its interaction with social media.

The share class initiative is continuing for enforcement. There was an emphasis to fix the problem before the SEC finds out if this has been an issue at your firm.

For exams, there is a focus on retail investors and in particular those saving for retirement. This includes a focus on how firms deal with older clients. The ReTIRE Initiative is still going strong. (They took great stride to point out that private fund investors are often retail investors.)

Exams are still focused on visiting firms that have never been examined. They are continuing the new registrant program.

The SEC has been learning how to use Form PF. It has been helping the SEC to inform its rule-making efforts. The experience with Form PF led to the separately-managed accounts questions on Form ADV.

Question & Answer Session 1
Speakers:

  • Ahmed Abdul-Jaleel, Assistant Regional Director, National Exam Program, Chicago Regional Office (Moderator)
  • Brian Blaha, Staff Accountant, National Exam Program, Denver Regional Office
  • Sara Cortes, Assistant Director, Division of Investment Management, Investment Adviser Regulation Office
  • Louis Gracia, Deputy Associate Regional Director, National Exam Program, Chicago Regional Office
  • Barbara Gunn, Assistant Director, Division of Enforcement, Asset Management Unit, Fort Worth Regional Office
  • Michael Spratt, Assistant Director, Division of Investment Management, Disclosure Review Office

When you get a document request list, ask questions if you are unsure what it’s asking for. If it’s going to take longer to produce the documents, let them know.

As for thoughts on the private equity fund exams and enforcement cases, does the SEC think the industry has changed? Yes. Limited partners are more informed. It’s not just fund managers, but gatekeepers who have failed to do their job of being a check on fund managers.

There was a fair amount of the liquidity rule. But since it does not apply to private funds, I’ve not been paying much attention to it or the questions about it.

One question was on anti-money laundering. It’s not the SEC who would be issuing the rules. It’s up to FinCEN. The SEC merely provides technical support.

Fees and Expenses Impacting Retail Investors
Speakers:

  • Louis Gracia, Deputy Associate Regional Director, National Exam Program, Chicago Regional Office (Moderator)
  • Adam Aderton, Assistant Director, Division of Enforcement, Asset Management Unit
  • Jennifer Porter, Branch Chief, Division of Investment Management, Investment Adviser Regulation Office
  • Nicole Tremblay, Senior Vice President and Chief Compliance Officer, Weston Financial

Lots of this panel’s material is in the new National Exam Program Risk Alert that came out today: Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers.

One panelist pointed out that “fees are negotiable” is generally not a good fee disclosure. Advisers should have a fee schedule.  If you let one client negotiated fees, you should state that lower fees can be negotiated.

The Sessions continue this afternoon, but I had to step away.

The One With The Fake Returns

Most frauds have some element of fake returns. I picked the case against McKinley Mortgage Co., Charles Preston, and his son, Caleb Preston because the headline in the release included: Private Real Estate Fund with Scheme to Defraud Retail Investors.” Frauds involving private real estate funds catch my attention.

McKinley bought promissory notes secured by deeds of trust or originated new loans, packaged them into investment pools and sold interests in the pools to investors.

According to the complaint, the problems started in 2012 when the sponsors started taking more in management fees and expenses than allowed under the fund documents. According to the complaint, it was an extra $700,000 in 2012 and $1.5 million in 2013. The it grew even bigger in subsequent years.

They also expanded the scope of investments. The fund documents said that up to 25% could be invested in Mexico. They exceeded that amount.

Then they increased the amount of returns from the funds to prospective investors.

Three bad things to do.

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Read SEC.gov on Your Phone

I had given up on trying to access the SEC’s online resources through my phone a long time ago. Frankly, it was hard to use with a full computer screen at times. It was nearly impossible to use on my phone’s small screen.

But the site has been evolving. Broc Romanek pointed out that the SEC’s home page is now mobile friendly. I looked around this morning while riding the train the work (a day off from bike-commuting). Most of the site works much better on a phone.

Of course that is great for consumers who are likely to be less frequent users and trying to get themselves some help. I might have moved the order of things around on the SEC’s home page to make it easier to make a complaint or research financial professionals. But the information is there and easy to find.

For industry users like me, it’s great to be able to find resources while out of the office. While on the SEC’s home page, I noticed that the SEC’s open meeting scheduled for today has been cancelled. There was a rumor circulating that the Commission was going to present updated guidance or a new rule on public company reporting requirements on data breaches. Clearly, that is not happening today.

If you were wondering, ComplianceBuilding.com is set up to be mobile-friendly. Let me know if it doesn’t work on your phone.

The SEC is Open on March 31

That headline is incorrect. I can’t speak for the entire SEC, especially with Congressional funding in jeopardy between now and then.

However, The IARD system is operating on March 31. If you have to file your Form ADV, it is due to be filed by March 31.

Back in 2013, March 31 fell on a Sunday and the IARD system did not work on the weekends back then. According to the calendar, the IARD system is now operating every day.  So, for you procrastinators, you don’t get extra time over the weekend to finish your Form ADV.

If you are the listed contact, you should have received this email:

IARD Availability on March 31 for Form ADV Annual Updating Amendment Deadline

Please be advised that the Investment Adviser Registration Depository (IARD) system will be open on Saturday, March 31, 2018, from 8am-6pm Eastern Time.  On that date,advisers will be able to submit filings, including amendments to Form ADV.  If an adviser’s fiscal year ended on December 31, 2017, that adviser will be able to file its Form ADV Annual Updating Amendment on March 31, 2018, in order to meet the requirement to file within 90 days after the end of its fiscal year.  If you have questions, please email [email protected].

If you have not noticed, there have been some significant changes to Form ADV.  See the Changes to Form ADV. It’s going to take some extra time to complete the filing this year.

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The Department of Justice Threw Out the Use of Guidance Documents

President Trump has set de-regulation as one of his priorities. We saw this in his Executive Order that required the repeal of two regulations before enacting a new regulation. The Department of Justice is embracing this mandate.

Associate Attorney General Rachel Brand issued a memorandum  limiting the use of agency guidance documents in affirmative civil enforcement cases. This is an extension of November 15, 2017 memo from Attorney General Sessions that prohibits the DOJ from promulgating guidance documents that create rights or obligations that are binding on regulated parties.

The Brand Memo applies to affirmative civil enforcement cases.  I was not sure what those were. I found out that they are civil lawsuits on behalf of the United States is to recover government money lost to fraud or other misconduct or to impose penalties for violations of Federal health, safety, civil rights or environmental laws. This would include ADA lawsuits, environmental clean up lawsuits, as well as healthcare reimbursement fraud.

The November memo from the Attorney General was intended to attack guidance that gets implemented as a de facto regulation without going through the formal notice and comment rulemaking process.

Any guidance documents now have to follow five principles:

  1. Guidance has to disclaim any force of law, and avoid language suggesting that the public has obligations that go beyond those set forth in the applicable statutes or legislative rules.
  2. Guidance must clearly state that they are not final agency actions, have no legally binding effect on persons or entities outside the federal government, and may be rescinded or modified.
  3. Guidance should not be used to coerce persons into taking any action or refraining from taking any action beyond what is required by the terms of the applicable statute or regulation.
  4. Guidance should not use mandatory language such as “shall,” “must,” “required,” or “requirement”, except when restating with citations to statutes or regulations.
  5. To the extent guidance set out voluntary standards, they should clearly state that compliance with those standards is voluntary and that noncompliance will not, in itself, result in any enforcement action.

This leaves me scratching my head on how this might affect guidance from the Securities and Exchange Commission that the compliance professionals rely on.

The Brand Memo clearly states that it applies to DOJ litigators in using other agencies’ guidance documents. Although, it limits itself to affirmative civil enforcement cases. I would have to assume that this may bleed over into the DOJ’s prosecution of cases referred from the SEC.

Guidance cuts both ways. Attorney General Sessions is clearly focused on guidance that imposes more obligations on regulated parties. But I think that is a simplistic way to look at things. Some of the guidance provides safeguards that help firms navigate uncertainty in the legislation and regulations.

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Federal Shutdown and Compliance

With Congress showing more of its ineptitude, it was unable to pass spending legislation over the weekend. There are reports of limited impact over the weekend. With today’s start of the work week, thousands of federal employees will be home instead of doing their jobs.

The Securities and Exchange Commission is still operational. At least in the short-term.

SEC Operating Status

Should there be a federal government shutdown after January 19, the SEC will remain open for a limited number of days, fully staffed and focused on the agency’s mission.

Any changes to the SEC’s operational status will be announced here. In the event that the SEC does shut down, we will pursue the agency’s plan for operating during a shutdown. As that plan contemplates, we are currently making preparations for a potential shutdown with a focus on the market integrity and investor protection components of our mission.

The SEC has a chunk of cash in reserve to keep operational. Some of its services are outsourced and will keep operating.

EDGAR

The Commission’s EDGAR system is operated pursuant to a contract and thus will remain fully functional as long as funding for the contractor remains available through permitted means. SEC personnel will be able to process requests for EDGAR access codes and password resets; answer questions about fee-bearing EDGAR filings and other emergency questions regarding EDGAR submissions. However, the Divisions of Corporation Finance, Investment Management, and Trading and Markets, and the Office of Compliance Inspections and Examinations will be unable to process filings, provide interpretive advice, issue no-action letters or conduct any other normal Division and Office activities. As a result, new or pending registration statements or applications for exemptive relief will not be processed regardless of the status of any review of those filings.

IARD

The Commission’s IARD system is operated pursuant to a contract and thus will remain fully functional and will continue to accept filings as long as funding for the contractor remains available through permitted means. However, the Office of Compliance Inspections and Examinations will be unable to approve applications for registration by investment advisers, the Division of Investment Management will be unable to provide interpretive advice regarding the Advisers Act, rules, or forms, or consider applications for exemptive relief under the Advisers Act. As a result, new or pending investment adviser applications will not be processed. The IARD system will continue to accept annual and other-than-annual amendments to Form ADV, Form ADV-W, and Form ADV-E filings.

It seems like any exams scheduled for this week could still happen. If you are looking start drafting your Form ADV filing, that system is still operational.

If the shutdown drags over into next week, the SEC will start its shutdown program. Anyone taking bets on that happening?

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The SEC Administrative Law Judges Are Heading to the Supreme Court

The use of administrative law judges by the Securities and Exchange Commission has been strained since the jurisdiction was expanded under Dodd-Frank. There have been a series of cases challenging the ALJs under the the Appointments Clause of the Constitution. The problem was that the judges were appointed by an internal panel instead of by the President or the SEC Commissioners.

An advertising case that led to an adviser being barred is now headed to the U.S. Supreme Court. In the Lucia case, the lower court used a three prong test to determine if an ALJ is an “Officer” under the Appointments Clause:

  1. significance of the matters resolved by the government official
  2. discretion the official exercises in reaching the decision
  3. the finality of the decision

On Jan. 12th, the Supreme Court granted an appeal to hear Lucia v. SEC. This was likely based on two factors.

One was a split in the courts on whether the SEC’s administrative law judges were properly appointed. The 10th Circuit Court of Appeals came to the opposite conclusion in Bandimere v. SEC. That court used a different three part analysis to determine if an ALJ is an “inferior officer”:

(1) the position of the SEC ALJ was “established by Law,”;
(2) “the duties, salary, and means of appointment . . . are specified by statute,”.; and
(3) SEC ALJs “exercise significant discretion” in “carrying out . . . important functions,” .

The Bandimere decision rejected the argument in the Lucia case that ALJs do not have final decision-making power. They have enough power to make them an “inferior officer.”

The second was that the Department of Justice decided that the ALJ appointment process was flawed. That position dropped in the Solicitor General’s Brief on Writ of Certiorari for Lucia the argument is now to hear the case and overturn the Lucia ruling.

“[T]he government is now of the view that such ALJs are officers because they exercise ‘significant authority pursuant to the laws of the United States.’ Buckley v. Valeo, 424 U.S. 1, 126 (1976)”

In response, the SEC ratified all the ALJ appointments. This should fix the problem and erase the constitutional problem.

In the reply brief, Lucia argued that the government’s change of its position and its revised procedures did nothing for him.

“Although the government now agrees that SEC ALJs are Officers, it has afforded petitioners no redress for having subjected them to trial before an unconstitutionally constituted tribunal… On the contrary, petitioners remain subject to draconian sanctions—including a lifetime associational bar—resulting from the tainted proceedings below”

It looks like the SEC has fixed the problem with its ALJs going forward. The problem will be what to do with all of the cases that have already been decided. It seems likely that the SEC is going to agree that the ALJs were a problem. The big question is how to fix that problem for the cases that have already been adjudicated. I would guess that there are a lot of cases that going be expunged, people no longer barred and cash fines repaid.

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Full Speed Ahead for the SEC

Commissioners Hester M. Peirce and Robert J. Jackson, Jr. are, According to Jay Clayton’s math the 96th and 97th Commissioners of the Securities and Exchange Commission after being sworn in last week.

It’s been two years since the SEC has been at full strength. Perhaps this means that rule-making will proceed ahead. Based on the SEC’s regulatory agenda, Chair Clayton is planning to have the commissioners focus on a much smaller set of rules in the near term.

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SEC Ratifies the Appointment of Administrative Judges

In a stunning turn, the Securities and Exchange Commission altered its treatment of the SEC’s administrative law judges. There have been several challenges to the constitutionality of these in-house judges. It appears that the Trump administration’s Department of Justice changed position and perhaps undercut the position of the SEC. That caused the SEC to change it’s appointment procedures for its administrative law judges.

The problem is that the judges are appointed by an internal panel instead of by the President or the SEC Commissioners. The Appointments Clause of the Constitution is there to make sure that those who wield power are subject to “political force and the will of the people.” The President appoints “Officers” who are those who exercise “significant authority pursuant to the laws of the United States.”

There is a split in courts on whether the system of appointing the SEC’s ALJs ran afoul of the Appointments Clause.

In the Lucia case, the court used a three prong test to determine if an official is an “Officer” under the Appointments Clause:

  1. significance of the matters resolved by the government official
  2. discretion the official exercises in reaching the decision
  3. the finality of the decision

But then there is the procedural matter of what happens after an SEC in-house judge issued his or her order. Under the SEC rules, there is not final decision until the Commission determines not to review the order. That initial order from the SEC judge only becomes final when the Commission issues the finality order. “The Commission’s final action is either in the form of a new decision after de novo review or, by declining to grant or order review, its embrace of the ALJ’s initial decision as its own.”

According to the Lucia court, that leaves the full decision-making powers in the hands of the SEC commissioners who are appointed by the President in accordance with the Appointments Clause.

The 10th Circuit Court of Appeals came to the opposite conclusion in Bandimere v. SEC. That court used a different three part analysis to determine if an ALJ is an “inferior officer”:

(1) the position of the SEC ALJ was “established by Law,”;
(2) “the duties, salary, and means of appointment . . . are specified by statute,”.; and
(3) SEC ALJs “exercise significant discretion” in “carrying out . . . important functions,” .

The Bandimere decision rejected the argument in the Lucia case that ALJs do not have final decision-making power. They have enough power to make them an “inferior officer.”

A split like this often gets a case heard by the Supreme Court to resolve the conflict. In October, the solicitor general argued in a brief that the US Supreme Court should not hear the Bandimere case and if it was inclined to spend time on the issue, the Lucia case was the better one to hear.

The other shoe dropped and in the Solicitor General’s Brief on Writ of Certiorari for Lucia the argument is now to hear the case and overturn the Lucia ruling.

“[T]he government is now of the view that such ALJs are officers because they exercise ‘significant authority pursuant to the laws of the United States.’ Buckley v. Valeo, 424 U.S. 1, 126 (1976)”

That means the way the SEC hires the judges may violate the Appointments Clause. The brief also notes that this “affects not merely the Commission’s enforcement of the federal securities laws, but also the conduct of adversarial administrative proceedings in other agencies within the government.”

The Supreme Court has not agreed to hear the case, so Mr. Lucia is not out of trouble yet.

The fix for the SEC has always been there. The SEC commissioners could appoint the ALJs directly instead of it going through an internal process. That does leave the door open for existing and past cases to be thrown out or placed in jeopardy.

The SEC put that fix in place. The SEC issued order on Thursday that directly ratified the appointment of the ALJs.

“To put to rest any claim that administrative proceedings pending before, or presided over by, Commission administrative law judges violate the Appointments Clause, the Commission— in its capacity as head of a department—hereby ratifies the agency’s prior appointment of Chief Administrative Law Judge Brenda Murray and Administrative Law Judges Carol Fox Foelak, Cameron Elliot, James E. Grimes, and Jason S. Patil.”

That fixes the problem going forward, causes delays in the current cases, and calls into question prior case decisions.

It’s not clear if the SEC agreed with change in position of the Solicitor General. It could have made this change after the Supreme Court ruled against the SEC. I leave it to others to speculate about whether the DOJ decided to make the change in position without the support of the SEC.

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The War at the CFPB

The Consumer Financial Protection Bureau has been a political hotspot since it was first proposed in the wake of the 2008 financial crisis. The Republican leadership miscalculated in blocking Elizabeth Warren from becoming the first CFPB Director, which allowed her to turn to election as Senator and becoming a much larger political figure. Her replacement just stepped down and created another political firestorm.

The CFPB is well insulated politically by having an independent director. (The Director can only be removed by the President for “inefficiency, neglect of duty, or malfeasance in office.”) It’s budget comes from the Federal Reserve. (That means it’s free from financial control by Congress.)  I respect the arguments that it is questionably positioned by having such unprecedented independence.

This independence apparently had an additional wrinkle since it’s enabling statute in Dodd-Frank has a provision for succession of the Director. When the Director is removed, the Deputy Director becomes acting Director until the President appoints and the Senate confirms a new Director. 12 U.S. Code § 5491(b). At least that is according to Leandra English who was appointed Deputy Director at 2:30 on November 24. The then-current Director, Richard Cordray resigned effective midnight on November 24.

President Trump appointed Director of the Office of Management and Budget Mick Mulvaney as Acting Director of the Consumer Financial Protection Bureau in a press release at 8:50 on November 24.

The President had the Department of Justice look at the law to strengthen his position. Steven Engel, the assistant attorney general for Office of Legal Counsel issued a memorandum over the weekend that cited the 1998 Federal Vacancies Act as giving the president the full authority to appoint an acting director to the Wall Street watchdog, notwithstanding the CFPB’s established line of succession.

“The fact that the Deputy Director may serve as Acting Director by operation of the statute, however, does not displace the President’s authority under the Vacancies Reform Act,”

Presumably, both Ms. English and Mr. Mulvaney would be heading to the same office this morning, with the entire CFPB wondering who is in control. But Ms. English stopped off in court on Sunday seeking a court order declaring her as Acting Director and holding that position until the President appoints and the Senate confirms a replacement.

This is certainly just applying a band-aid to a gaping head wound. There will be a new Director shortly and that Director will do everything he (or she) can to shut down the CFPB within the statutory requirements.

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