Bruce Carton of Securities Docket, Francine McKenna of Re: The Auditors and I are attending the SEC’s news conference virtually and taking notes using the CoverItLive tool embedded below.
Tag: SEC
Custody of Funds or Securities of Clients by Investment Advisers
The SEC released the final version of its new custody rule (.pdf). The Commissioners had announced their approval of the rule on December 17 and then released the final text on December 30. The rule goes into effect 60 days after publication in the Federal Register.
The amendments are designed to provide additional safeguards under the Advisers Act when a registered adviser has custody of client funds or securities by requiring such an adviser, among other things: to undergo an annual surprise examination by an independent public accountant to verify client assets; to have the qualified custodian maintaining client funds and securities send account statements directly to the advisory clients; and unless client assets are maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related person), to obtain, or receive from a related person, a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board. Finally, the amended custody rule and forms will provide the Commission and the public with better information about the custodial practices of registered investment advisers.
This new custody rule is designed to catch a Madoff fraud.
The rule is limited in scope. Only SEC-registered investment advisories that control custody of their client’s assets – as Madoff did — are subject to the rule. Independent RIAs with client assets in custody with unaffiliated third parties are exempt from the final version of the rule.
The difference is that the SEC exempted investment advisers who were deemed to have custody merely because they had the authority to deduct their advisory fees from client accounts from the surprise audit requirement. The SEC also exempted pooled investment vehicles from the requirement if they have an annual GAAP audit by an independent public accountant.
Between 1,500 and 1,900 SEC-registered investment advisories provide in-house custody of securities and most of these are either broker-dealer affiliates or alternative-investment managers. This leaves well over 9,000 SEC-regulated RIAs and at least that many state-registered investment adviser firms free from the burdens of the rule. The SEC estimates the annual cost of compliance at about $8,000 a year, but TD Ameritrade estimates the cost is closer to $25,000 per year.
References:
- Text of Rule IA-2968
- SEC Approves New Custody Rule – prior post
- SEC Releases Proposed Custody Rules for Investment Advisers – prior post
- Most Investment Advisers Escape Madoff Audits from the WSJ.com’s Financial Adviser
SEC Approves New Custody Rule
The Securities and Exchange Commission adopted the proposed Custody Rule for investment advisers originally proposed last May. (See: SEC Releases Proposed Custody Rules for Investment Advisers)
As is typical with the SEC, they announced the rule was approved before they made the final version of rule available. The rule amendments will be effective 60 days after their publication in the Federal Register.
The SEC press release highlights the two biggest changes:
Surprise Exam
“The adviser is now required to engage an independent public accountant to conduct an annual “surprise exam” to verify that client assets exist. Such a surprise examination would provide another set of eyes on the client’s assets, and provide additional protection against theft or misuse. The accountants would have to contact the SEC if they discovered client assets were missing.”
Custody Controls Review
“When the adviser or an affiliate serves as custodian of client assets, the adviser is now required to obtain a written report — prepared by an accountant that is registered with and subject to regular inspection by the PCAOB — that, among other things, describes the controls in place at the custodian, tests the operating effectiveness of those controls and provides the results of those tests. These reports are commonly known as SAS-70 reports. Requiring that the accountant be registered with and subject to inspection by the PCAOB provides greater confidence regarding the quality of these reports.”
The rules are amendments to Rule 206(4)-2 [17 CFR 275.206(4)-2], Rule 204-2 [17 CFR 275.204-2] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (the “Advisers Act” or “Act”), to Form ADV [17 CFR 279.1], and to Form ADV-E [17 CFR 279.8].
References:
- SEC Releases Proposed Custody Rules for Investment Advisers – Prior post
- Text of Rule as initially proposed Release No. IA-2876 (.pdf).
- SEC Press Release: SEC Approves Stronger Safeguards to Protect Clients’ Assets Controlled by Investment Advisers
- SEC Requires Surprise Exams in Response to Madoff Ponzi Scheme by Jesse Westbrook for Bloomberg
- SEC Approves Custody Rule Changes in Compliance Avenue
How Fraudsters Try to Look Legitimate
The SEC is putting its new investor-focused website to good use: Investor.gov.
The first item that caught my eye was their article on how fraudsters use fake SEC registrations and bogus seals to make them look legitimate: Fake Seals and Phony Numbers: How Fraudsters Try to Look Legit.
They offer these five pieces of advice:
- Deal Only With Real Regulators
- Be Skeptical of Government “Approval”
- Look Past Fancy Seals and Impressive Letterheads
- Check Out the Broker and the Firm
- Be Wary of “Advance Fee” or “Recovery Room” Schemes
“If you want to invest wisely and steer clear of frauds, you must get the facts. Never, ever, make an investment based solely on a promoter’s promises or what you see on the Internet”
The other thing that caught my eye as a blogger, was the SEC’s use of an out of the box WordPress blog deployment to run the Investor.gov website. Just like I use here at Compliance Building.
Review of SEC’s Process for Selecting Adviser Examination Targets
To continue the Madoff dogpile on the SEC, the SEC’s Office of Inspector General released a report criticizing the SEC’s process for selecting investment advisers and investment companies for examination.
As a result of OCIE never having examined Madoff’s investment firm, the Inspector General conducted this review to determine OCIE’s rationale for not performing an examination of Madoff’s investment advisory business. They came up with 11 recommendations:
Recommendation 1:
The Office of Compliance Inspections and Examinations (OCIE) should implement a procedure requiring, as part its process for creating a risk rating for an investment adviser, that OCIE staff perform a search of Commission databases containing information about past examinations, investigations, and filings related to the investment adviser.
Recommendation 2:
The Office of Compliance Inspections and Examinations (OCIE) should change the risk rating of an investment adviser based on pertinent information garnered from all Divisions and Offices of the Commission, including information from OCIE examinations and Enforcement investigations, regardless of whether the information was learned during an examination conducted to look specifically at a firm’s investment advisory business.
Recommendation 3:
The Division of Enforcement and the Office of Compliance Inspections and Examinations should establish and adhere to a joint protocol providing for the sharing of all pertinent information (e.g., securities laws violations, disciplinary history, tips, complaints and referrals) identified during the course of an investigation or examination or otherwise.
Recommendation 4:
The Office of Compliance Inspections and Examinations (OCIE) should establish a procedure to thoroughly evaluate negative information that it receives about an investment adviser and use this information to determine when it is appropriate to conduct a cause examination of an investment adviser. OCIE should ensure its procedure provides for timely opening of a cause examination.
Recommendation 5:
When the Office of Compliance Inspections and Examinations (OCIE) becomes aware of negative information pertaining to an investment adviser, OCIE should examine the investment adviser’s Form ADV filings and document and investigate discrepancies existing between the adviser’s Form ADV and information that OCIE previously learned about the registrant.
Recommendation 6:
The Office of Compliance Inspections and Examinations (OCIE) should establish a procedure to thoroughly evaluate an investment adviser’s Form ADVs when OCIE becomes aware of issues or problems with an investment adviser. OCIE should document areas where it believes a Form ADV contains false information and initiate appropriate action, such as commencing a cause examination.
Recommendation 7:
The Office of Compliance Inspections and Examinations (OCIE) should re-evaluate the point scores that it assigns to advisers based on their reported assets under management. OCIE should assign progressively higher risk weightings to firms that have greater assets under management.
Recommendation 8:
The Office of Compliance Inspections and Examinations (OCIE) should re-evaluate the point scores that it assigns to firms based on their reported number of clients to which they provide investment advisory services. OCIE should assign progressively higher risk weightings to investment advisers that serve a larger number of clients.
Recommendation 9:
The Office of Compliance Inspections and Examinations (OCIE) should recommend to the Chairman’s office that it institute a Commission rulemaking that would require the following additional information to be reported as part of Form ADV:
• Performance information;
• A fund’s service providers, custodians, auditors and administrators, and applicable information about these entities;
• A hedge fund’s current auditor and any changes in the auditor; and
• The auditor’s opinion of the firm.
Recommendation 10:
The Commission should finalize the proposed rule titled Amendments to Form ADV [Release No. IA-2711; 34-57419]. In finalizing this rule, the Commission should consider what, if any, additional information investment advisers should include in Part II of Form ADV by consulting with the Office of Compliance Inspections and Examinations (OCIE) and the Division of Investment Management (IM). Further, the Commission, in consultation with OCIE and IM, should consider provisions that would assist OCIE to efficiently and effectively review and analyze the information in Part II of Form ADV.
Recommendation 11:
The Office of Compliance Inspections and Examinations (OCIE) should develop and adhere to policies and procedures for conducting third party verifications, such that OCIE verifies the existence of assets, custodian statements, and other relevant criteria.
This is now the fourth report the SEC’s OIG has issued as a result of Madoff, following up on:
- Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme, Report No. 509;
- Program Improvements Needed Within the SEC’s Division of Enforcement, Report No. 467; and
- Review and Analysis of OCIE Examinations of Bernard L. Madoff Investment Securities, LLC, Report No. 468.
Federal Regulators Issue Final Model Privacy Notice Form
Eight federal regulatory agencies today released the final model privacy notice form. It’s supposed to make it easier for consumers to understand how financial institutions collect and share information about consumers. Under the Gramm-Leach-Bliley Act, institutions must notify consumers of their information-sharing practices and inform consumers of their right to opt out of certain sharing practices. The two model form issued today can be used by financial institutions to comply with these requirements. One form allows consumers to opt out of sharing of personal information. The other form has no opt-out.
Back in April, the Securities and Exchange Commission reopened the period for public comment because they tested the model notices and found weaknesses with the current form.
The final model privacy form was developed jointly by the Board of Governors of the Federal Reserve System, Commodity Futures Trading Commission, Federal Deposit Insurance Corporation, Federal Trade Commission, National Credit Union Administration, Office of the Comptroller of the Currency, Office of Thrift Supervision, and Securities and Exchange Commission. There is also a joint release of the rule that goes along with the Final Model Privacy Form under the Gramm-Leach-Bliley Act
References:
- SEC Press Release: Federal Regulators Issue Final Model Privacy Notice Form
- Final Rule SEC 17 CFR Part 248 [Release Nos. 34-61003, IA-2950, IC-28997; File No. S7-09-07] RIN 3235-AJO6
- Model form with opt-out
- Model form with no opt-out
- Privacy Notices – Testing Effectiveness – prior post
Fund Registration Act Will Cost the SEC $140 Million
The Congressional Budge Office released a cost estimate of H.R. 3818, the Private Fund Investment Advisers Registration Act of 2009. Obviously, there will be an additional cost to fund managers that need to register with the SEC and operate under the SEC rules and oversight. There is also a real cost to the SEC (and therefore the taxpayers) for supervision of the newly regulated fund advisers.
The CBO estimates that the SEC will need an additional $140 million over the 2010-2014 period to implement the provisions of H.R. 3818. That means 150 employees new SEC employees by fiscal year 2011 to write regulations and undertake the additional examination and enforcement activities required by the bill. That’s about a 4 percent increase over the SEC’s 2009 staffing levels. The $140 million is to cover the cost of salaries and benefits, overhead, preparation of reports, and upgrades to information technology systems for the new employees.
The CBO report estimates that H.R. 3818 would result in 1,300 new registrations. That excludes venture capital funds which are exempted under this bill, but does include private equity firms that are exempted under the Senate version of the Private Fund Investment Advisers Registration Act. Doing the math, that results in $108,000 in additional costs for each new fund manager that registers.
On the manager side, the CBO estimates that it will only cost $30,000 for each fund manager to comply with Private Fund Investment Advisers Registration Act of 2009.
References:
Accidental Securities Underwriter
So you made almost $1 million on selling penny stocks through the pink sheets on $75,000. Nice pay day. Then the SEC makes you give it all back.
This is the sad tale of Rodney Schoemann, a professional stock market trader.
Schoemann had previous purchased some restricted shares in Stinger Systems, Inc. that were marked “RESTRICTED” on their face. He apparently thought the company was worth investing in, so he asked to purchase 100,000 unrestricted shares from one of the company’s insiders. Schoemann paid the insider at the company $0.75 per share, which were not marked with a restriction. He later deposited the shares with his broker and sold them to the public.
Unfortunately, those 100,000 were not registered and that insider was in control of the issuer.
An administrative law judge found that Schoemann violated Sections 5(a) and 5(c) of the Securities Act of 1933 in November 2004 by offering and selling the securities of Stinger Systems, Inc.when no registration statement was filed or in effect for those securities and no exemption from registration was available.
Securities Act Section 5(a) prohibits any person, directly or indirectly, from selling a security in interstate commerce unless a registration statement is in effect as to the offer and sale of that security or there is an applicable exemption from the registration requirements. Securities Act Section 5(c) prohibits the offer or sale of a security unless a registration statement as to such security has been filed with the Commission, or an exemption is available.
Schoenmann argued that he was not an underwriter. But individual investors may be deemed “underwriters” within the statutory meaning of that term if they act as links in a chain of securities transactions from issuers or control persons to the public.
Section 2 of the Securities Act has this definition:
The term “underwriter” means any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking; but such term shall not include a person whose interest is limited to a commission from an underwriter or dealer not in excess of the usual and customary distributors’ or sellers’ commission. As used in this paragraph the term “issuer” shall include, in addition to an issuer, any person directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect common control with the issuer.
From the testimony, both Shoemann and the insider thought the shares were freely transferable. The insider did not think he was a control person and Shoemann never inquired the insider to see if he was control person.
Shoemann did see a legal opinion that shares in Stinger Systems, Inc. were freely tradeable. This opinion was submitted to the transfer agent and the Pink Sheets. Advice of counsel is not a defense, since it merely goes to the question of scienter.
A showing of scienter is not required to establish a violation of Section 5. There is strict liability.
The last test was whether Shoemann had purchased the shares for distribution. This test involves intent. Since Shoemann sold all 100,000 shares in the two weeks after he purchased them, he would have a hard arguing that he did not intend to distribute them. So Schoemann served as a link in a chain of transactions where securities moved from the issuer to the public, and in doing so, served as an underwriter.
The deal made financial for Shoemann, but he failed to realize the legal background on the shares. The SEC made him disgorge his $967,901 ($1,042,901 in gross proceeds, minus Schoemann’s initial $75,000 purchase price) from his “violative sales” of Stinger stock. In addition to the disgorgement of profits, he has to pay prejudgment interest of $335,370.98.
References:
- SEC Opinion 33-9076 In the Matter of Rodney R. Schoemann
- $967,000 Disgorgement Order based on Unregistered Stock Sales Upheld by Robert Fusfeld for the SEC Tea Party
- Commission Finds that Rodney R. Schoemann Sold Unregistered Securities When No Exemption from Registration Was Available – press release
Draft SEC Strategic Plan for 2010-2015
The Securities and Exchange Commission is seeking comment on its draft Strategic Plan. The document includes drafts of the SEC’s mission, vision, values, strategic goals, major initiatives, and performance metrics for fiscal years 2010 through 2015.
Draft SEC Strategic Plan for 2010-2015
Here is the new vision: The SEC strives to promote a market environment that is worthy of the public’s trust and characterized by transparency and integrity.
Here are the Strategic Goals and Outcomes:
Strategic Goal 1: Foster and enforce compliance with the federal securities laws
Outcome 1.1: The SEC fosters compliance with the federal securities laws.
Outcome 1.2: The SEC promptly detects violations of the federal securities laws.
Outcome 1.3: The SEC prosecutes violations of federal securities laws and holds violators accountable.
Strategic Goal 2: Establish an effective regulatory environment
Outcome 2.1: The SEC establishes and maintains a regulatory environment that promotes high quality disclosure, financial reporting, and governance, and that prevents abusive practices by registrants, financial intermediaries, and other market participants.
Outcome 2.2: The U.S. capital markets operate in a fair, efficient, transparent, and competitive manner, fostering capital formation and useful innovation.
Outcome 2.3: The SEC adopts and administers rules and regulations that enable market participants to understand clearly their obligations under the securities laws.
Strategic Goal 3: Facilitate access to the information investors need to make
informed investment decisions
Outcome 3.1: Investors have access to high-quality disclosure materials that are useful to investment decision making.
Outcome 3.2: Agency rulemaking and investor education programs are informed by an understanding of the wide range of investor needs.
Strategic Goal 4: Enhance the Commission’s performance through effective alignment and management of human, information, and financial capital
Outcome 4.1: The SEC maintains a work environment that attracts, engages, and retains a technically proficient and diverse workforce that can excel and meet the dynamic challenges of market oversight.
Outcome 4.2: The SEC retains a diverse team of world-class leaders who provide motivation and strategic direction to the SEC workforce.
Outcome 4.3: Information within and available to the SEC becomes a Commission-wide shared resource, appropriately protected, that enables a collaborative and knowledge-based working environment.
Outcome 4.4: Resource decisions and operations reflect sound financial and risk management principles.
SEC’s Office of Compliance Inspections and Examinations Gets a Review
The SEC’s Division of Enforcement was not alone in getting a report from the SEC’s Inspector General: Improvements Needed Within the SEC’s Division of Enforcement. The Office of Compliance Inspections and Examinations also got a review from the Inspector General: Review and Analysis of OCIE Examinations of Bernard L. Madoff Investment Securities, LLC. 
For this report, the Office of the Inspector General hired FTI Consulting, Inc. to help with the review. Not to be outdone by the report on the Division of Enforcement, FTI came up with 37 recommendations, topping the other report’s 21 recommendations.
So far that’s a total of three reports and 58 recommendations from the SEC’s Inspector General as a result of the Madoff incident.
References: