Category: SEC News

SEC’s In-House Courts Are Upheld

There have been several challenges to the constitutionality of the in-house judges at the Securities and Exchange Commission. The problem is that the judges are appointed by an internal panel instead of by the President or the SEC Commissioners. That will not make a difference for Raymond Lucia and his “Buckets of Money.”

SEC Seal 2

Radio personality Raymond J. Lucia, Sr. got in trouble with the SEC by claiming that his “Buckets of Money” strategy had been successfully backtested when in fact it had not been. Lucia was a registered investment advisor, but the SEC barred him for his transgressions. He appealed.

In addition to appealing the substance of the charges against him, he argued that the SEC in-house court was unconstitutional. The appeal looked at the Appointments Clause of the Constitution. It’s an important part of the constitution 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.”

The court went out to point out 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

So far it sounds good for Mr. Lucia and the other parties arguing this point in their disciplinary matters.

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.”

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.

That seems to settle the argument that the SEC in-house administrative proceedings are unconstitutional.

Of course, Mr. Lucia could appeal this decision further. The Supreme Court may want to take a different view of who is an “officer” under the Appointments Clause.

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Cycling and the Securities and Exchange Commission

The big news in cycling over the weekend was the end of the Tour de France. Other news is a personnel change at the Securities and Exchange Commission because of cycling.

sky and froome

Chris Froome and his Team Sky dominated the General Classification of the Tour de France. He finished more that four minutes ahead of his nearest rival. He took the yellow jersey and the initial time advantage in an unusual manner. He attacked at the top of a big climb while his rivals paused. He was gone before they realized what happened. In a later stage he gained more time in an unusual attack paired with Peter Sagan, the holder of the sprinters’ green jersey, and two teammates when crosswinds fractured the peloton. In the usual manner Froome gained time on his rivals in the time trials and held off their attacks in the mountains using his incredibly strong team.

For the SEC, the Chief Accountant, James V. Schnurr, was in a serious bicycle crash. Serious enough that the SEC appointed Wesley R. Bricker as the Interim Chief Accountant.

I was disappointed that the SEC chose to use the word “accident” in the press release. Accident applies that there was no fault and perhaps was not preventable. Unfortunately, I was not able to find a news story about the crash.

As someone who regularly bikes to work, I can tell you that there are few accidents. Of course there are cyclists breaking the law. (I still don’t understand why so many run red lights.) But a bike is going to little damage if it crashes into a car. A car will do tremendous damage if it crashes into a cyclist.

I see many, many distracted drivers while on my bike commute: watching videos, texting, emailing, facebooking, catching pokemons. They seem oblivious that they are directing 3000 pounds of metal with potentially deadly force.

It’s not an “accident” when the driver has chosen to be distracted. “I didn’t see him,” is more often because the driver chose to pay attention to some other distraction instead of the other cars, cyclists and pedestrians in and around the roadway.

I hope you are not one of those distracted drivers.

On a happy note, this is one of the great watercolors by Greig Leach for sale at The Art of Cycling. This one captures the battle of sprinters at the end of stage 3. But you’ll have to pick one of the other watercolors because this one is in my living room.

If you enjoy Compliance Building, please support my Pan-Mass Challenge ride to fight cancer on August 5-7. 100% of your donation goes to the fight against cancer. You can read more and donate here: http://profile.pmc.org/DC0176

Photo Finish in Angers small

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Share Class Initiative

If your firm receives revenue from the sale of funds, be sure you have procedures in place to avoid placing clients in a more expensive share class when a cheaper one is available. The SEC announced a new Share Class Initiative for 2016.

There are two main areas where an adviser will have conflict in this area.

  1. A firm where the adviser is also a broker-dealer or affiliated with a broker-dealer that receives fees from sales of certain share classes
  2. Situations where the adviser recommends that clients purchase more expensive share classes of funds for which an affiliate of the adviser receives more fees.

Those are obvious situations where the adviser has a conflict.

The alert highlights the March action against Everhart Financial Group. The firm was collecting 12b-1 fees from mutual funds that it directed its clients to buy. The firm failed to disclose that it was collecting those fees. The firm later revised its advisory agreements and stated:

EFG’s representatives “may receive 12b-1 fees from certain mutual funds… . Receiving 12(b)-1 fees represents an incentive for a registered representative to recommend funds with 12(b)-1 fees or with higher 12(b)-1 fees than funds with no fees or lower fees.”

Disclosure did not seem to be enough. EFG did not present its clients with information on funds that did not pay 12b-1 fees to the firm. It did not seem to have a good basis for when it would chose a fund with a fee and when it would not. There was no procedure for discussing cheaper class funds with clients. This was a best execution failure.

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Chaos in Commissioner Confirmation

I thought the picks for Securities and Exchange Commissioner would fly through the confirmation process. I was clearly wrong and Congress is even more dysfunctional than I thought.

fairfax and peirce

The SEC is now down to just three members after two left the agency late last year. President Obama nominated Lisa Fairfax, a Democrat, and Hester Peirce, a Republican, to fill the vacancies. Each side of the political divide would likely find one acceptable and accept the other as part of a package.

The discussion about the nominees was held in executive session so we don’t know exactly what was said.

Many groups have urged the SEC to adopt a rule requiring public companies to disclose political donations to nonprofit groups that can spend unlimited amounts of money on political advocacy and advertising. Direct corporate contributions to candidates and party committees already are disclosed. Personally, I don’t see how that affects the SEC missions to protect consumers and have healthy capital markets. The argument is that shareholders should know which political candidates or causes are receiving their money.

Four Senators are holding up the nomination based on this issue. Charles Schumer of New York and Robert Menendez of New Jersey, said they would oppose the SEC picks. They are joined by Elizabeth Warren of Massachusetts and Jeff Merkley of Oregon.

The four Senators feel that the nominees don’t have sufficient belief in further regulating campaign spending by public companies. It will be curious how this should be handled since the 2016 spending bill explicitly denied the SEC the funds to issue or implement this rule.

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The SEC’s New Office of Risk and Strategy

Whenever the Securities and Exchange Commission reorganizes you have to wonder what the impact will be on those subject to regulation by the SEC. Earlier, the SEC announced a new Office of Risk and Strategy within the Office of Compliance Inspections and Examination.

SEC Seal 2

“The Office of Risk and Strategy will lead our exam program’s risk-based, data-driven, and transparent approach to protecting investors,” said OCIE Director Marc Wyatt. According to the SEC’s press release “[t]he new office will consolidate and streamline OCIE’s risk assessment, market surveillance, and quantitative analysis teams and provide operational risk management and organizational strategy for OCIE.”

I think it’s a good thing for OCIE to increase its use of data in looking at risky firms. The amount of data coming into the SEC has increased dramatically with addition of private fund managers into SEC registration, the Form PF filings and increased trade review.

The news has been sparse as to whether the new office is a new initiative or merely a centralization of existing initiatives. OCIE has been saying for years that its exam process is risk driven. Leading up to an exam, OCIE has looked at many other firms to determine that those present fewer risks.

Hopefully, the new office will allow the SEC to better focus on firms with greater risk.

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Another Potential Reason for Companies Not to Go Public

Cybersecurity is a real threat and needs to be taken seriously. But is it a Board of Directors level issue for all public companies? I don’t think so. But apparently Senators Jack Reed and Susan Collins think that is. That would mean another headache for public companies.

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Of course there may be some companies that need cybersecurity as a priority for a seat in the boardroom. Does a pharma company trying to create a new drug need to devote a precious board seat to a cybersecurity expert?

The legislation imposes an obligation on the Securities and Exchange Commission to implement this concept.

It also requires the SEC to work with the National Institute of Standards and Technology to define what constitutes expertise or experience in cybersecurity. That of course is whole other issue. There are lots of people out there claiming to be cybersecurity experts. The best are likely trying to hack into your system right now.

I’m sure cybersecurity experts are frothing at the concept of getting board seats. Unfortunately, it will take away a seat from someone who might bring better expertise to the company.

Like the conflict minerals legislation, it’s another rule that brings little protection to investors but imposes large costs and difficulties on public companies.

As you might expect, the SEC has it’s own cybersecurity issues. I wonder if one of the SEC Commissioners will be required to have cybersecurity expertise.

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Brian Klug: Anonymous Hacker
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Are There Real Estate Fund Enforcement Cases Coming From the SEC?

Eighteen months ago, Andrew Bowden gave his Sunshine speech on the SEC’s disapproval of private equity fee compliance. Now, enforcement cases are being finalized on private equity fees. The SEC is just now finishing a focus on real estate funds. Should we be looking for real estate fund enforcement cases on the horizon?

Boston Skyline - Pink Panoramic

While listening to one of the panels at the Coping with Regulatory Change conference this week, a representative of the SEC mentioned that the SEC had been working on a exam focus of real estate funds. You may remember that Marc Wyatt mentioned this exam focus in a speech this spring at PEI’s Private Fund Compliance Forum.

Bowden’s speech set the stage for the fee and expense enforcement actions that are coming out. See Blackstone, Cherokee, Fenway for examples. It seems reasonable for there to be an 18 month window to examine, investigate, enforce, and settle the cases that SEC deems worthy.

The SEC has conducted a focus on real estate funds.

I would hope that all of the real estate fund managers have read the stories on Compliance Building over the last six years and made the compliant and ethical choices for their firms. If so, hopefully they came out of the exams with either clean exams or merely minor comments.

However, I fear that the SEC found real estate fund managers that were not being compliant and that were not acting ethically. That would mean that enforcement cases are in the pipeline.

When I asked that SEC representative whether there were enforcement cases in the pipeline against real estate fund managers. He or she gave the correct answer of “No comment.”

I leave it to you to interpret that response.

I think I see something on the horizon.

Image: Boston Skyline – Pink Panoramic by Noah B. Kaplan
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The Female SEC Will be Taking on the Old Boys’ Club of Wall Street

President Obama nominated Lisa Fairfax and and Hester Peirce to fill the two vacant positions on the Securities and Exchange Commission. They will join May Jo White and Kara Stein. That leaves Michael Piwowar alone with his Y-Chromosome.

fairfax and peirce

Fairfax is a law professor and director for programs at George Washington’s Center for Law, Economics and Finance.  Fairfax is an expert on shareholder activism.

Peirce is a senior research fellow at George Mason and director of the financial markets working group at the university’s Mercatus Center. Peirce served on Senator Richard Shelby’s staff on the Senate Committee on Banking, Housing, and Urban Affairs. In that position, she worked on financial regulatory reform following the financial crisis of 2008 as well as oversight of the regulatory implementation of the Dodd-Frank Act. Peirce served at the Securities and Exchange Commission as a staff attorney and as counsel to Commissioner Paul S. Atkins

If confirmed, Fairfax would take the Democrat slot by replacing Luis Aguilar, whose term has expired. Peirce would take the Republican slot and replace Daniel Gallagher who stepped down in early October.

The President is able to placate both the right and the left with the two nominations. It will be interesting to see what direction the SEC turns to once the two new commissioners take their seats.

 

What Does the Future Hold for the Regulation of Private Equity Funds?

The Chair of the Securities and Exchange Commission offered a sneak peak of upcoming regulations. Mary Jo White was speaking at the 75th Anniversary Celebration: Investment Company and Investment Advisers Acts and offered a few tidbits.

fortune tell secret crystal ball

Chair White spoke about the history of the Acts and offered a glimpse into the future:

Today, as many of you know, the Commission has an ambitious agenda to address evolving risks for funds and advisers, recently proposing enhanced data reporting by investment companies and advisers, and, just last week, proposing to require open-end funds to enhance funds’ liquidity risk management. As we speak, Commission staff is also developing recommendations that I hope to advance for the Commission’s consideration by the end of this year related to the use of derivatives by funds, including measures to appropriately limit the leverage these instruments may create, as well as enhancing risk management programs for such activities.

Beyond that, the staff is developing recommendations regarding transition planning for advisers, annual stress testing by large investment advisers and funds, a program of third party examinations for investment advisers and a uniform fiduciary duty for investment advisers and broker-dealers.

Talk about a full plate of critical initiatives.

The SEC wants to limit the use of derivatives by funds. It’s not clear whether that would applicable to all funds or focused on mutual funds.

Transition planning for advisers is a hot button. It’s certainly an issue for small retail advisers. It’s also a question for many private fund managers. It will be interesting to see what the SEC will propose.

Annual stress testing for large funds will be tricky. I wonder how the SEC will define “large.”

Third-party exams for investment advisers is back on the table. That will mean more costs to registered advisers having to pay for the service of being examined more regularly. I’m sure FINRA popped its head up when it saw that line in the speech.

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Fortune Telling
by Russ Allison Loar
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New SEC Rulemaking Database

Strong rulemaking is central to the mission of the Securities and Exchange Commission. Transparency to the process is important so the affected parties can provide input and see changes coming. To help with mission and to improve transparency, the SEC launched a new database intended to provide better transparency.

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I applaud any effort the SEC takes to make it easier for compliance professionals to find, understand and implement its regulatory scheme.

I decided to try out the index/database and share my initial thoughts.

The new database does provide a better single source for lots of the SEC rules. It’s better than the current chronological listing of rules. But not not that much better.

The rules have three sortable fields:

  • Last action
  • File number
  • Title of rulemaking

The first two are not useful. Anyone remember the date the rule was proposed or the file no.? No I didn’t think so. The title is useful if you know the name and the name is descriptive.

I decided to look for two rulemaking that interest me: Crowdfunding implementation under the JOBS Act and General solicitation amendments to Form D and the private placement regime.

I had trouble. I didn’t know the date or the file number or the name. I have the choice to limit the rules displayed by Status: “All”, “complete” or “Proposed”. I also had the choice to limit the display by SEC division. None of these choice are particularly useful for the layperson. I’m not sure any of the database choices are even useful for compliance professionals.

The database lacks a separate search.

Fortunately, I have this website so I could search for the post about the changes, find the relevant SEC document and locate the file number on the document so I could use the database.

I found my post on the proposed amendments to Rule 506 and Form D that were released at the time the SEC issued the new Rule 506(c) allowing general solicitation. In the SEC’s database I see that the database shows the proposed rule and second rule re-opening the comment period.  I’m not sure I could have found that entry if it were not for this website.

Fortunately, the crowdfunding regulation was actually called “Crowdfunding” so it was easier to spot by sorting the “rulemaking” column.

I did notice that the Naked Short Selling Anti-Fraud rule is out of order because it is titled “Naked” Short Selling Anti-Fraud, with the punctuation disrupting the alphabetical sort.

 

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