Tag: SEC

Improvements Needed Within the SEC’s Division of Enforcement

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The SEC’s Inspector General, H. David Kotz, released his most recent report: Program Improvements Needed Within the SEC’s Division of Enforcement.pdf-icon

The report is sort of a follow-up to the Madoff Report. The Office of the Inspector General conducted a review “to identify systemic issues that would prevent Enforcement from accomplishing its mission to enforce the securities laws and protect investors and determine from discussions with staff and supervisors which programmatic improvements are needed.”

The Inspector General’s 21 recommendations are:

  1. Establish formal guidance for evaluating various types of complaints (e.g., Ponzi schemes) and train appropriate staff on the use of the guidance. The guidance should address the necessary steps and key information required to be collected when conducting preliminary inquiries of various types of complaints, specify what information should be documented, and list whom should be consulted in other offices within the SEC with relevant expertise in various subject matters and other pertinent data.
  2. Ensure the SEC’s tip and complaint handling system provides for data capture of relevant information relating to the vetting process to document why a complaint was or was not acted upon and who made that determination.
  3. Require tips and complaints to be reviewed by at least two individuals experienced in the subject matter prior to deciding not to take further action.
  4. Establish guidance to require that all complaints that appear on the surface to be credible and compelling be probed further by in-depth interviews with the sources to assess the complaints validity and to determine what issues need to be investigated. Such guidance should also require that staff obtain all relevant documentation related to such complaints.
  5. Provide training to staff to ensure they are aware of the guidelines contained in Section 3.2.5 of the Enforcement Manual and Title 17 of the Code of Federal Regulations, Section 202.10 for obtaining information from media sources.
  6. Annually review and test the effectiveness of its policies and procedures with regard to its new tip and complaint handling system. Enforcement should also modify these policies and procedures, where needed, to ensure adherence and adequacy.
  7. Put in place procedures to ensure that investigations are assigned to teams where at least one individual on the team has specific and sufficient knowledge of the subject matter (e.g. Ponzi schemes) and the team has access to at least one additional individual who also has such expertise or knowledge.
  8. Train staff on what resources and information is available from the national specialized units and when and how assistance from these units should be requested.
  9. Make it mandatory that planning memoranda be prepared during an investigation and that the plan includes a section identifying what type of expertise or assistance is needed from others within and outside the Commission. The plan should also be reviewed and approved by senior Enforcement personnel.
  10. Require that after the planning memorandum is drafted, it is circulated to all team members assigned to the investigation, and all team members then should meet to discuss the investigation approach, methodology and any concerns team members wish to raise.
  11. Establish procedures so that junior-level Enforcement attorneys who are having difficulty with obtaining timely assistance from outside offices are able to escalate their concerns to senior-level management within Enforcement.
  12. Conduct periodic internal reviews of any newly implemented policies and procedures related to information sharing with Divisions and Offices outside of Enforcement to ensure they are operating efficiently and effectively and necessary changes are made.
  13. Require that the planning memorandum and associated scope, methodology and timeframes be routinely reviewed by an investigator’s immediate supervisor to ensure investigations remain on track and determine whether adjustments in scope, etc. are necessary.
  14. Ensure that sufficient resources, both supervisory and support, are dedicated to investigations upfront to provide for adequate and thorough supervision of cases and effective handling of the investigations.
  15. Put in place policies and procedures or training mechanisms to ensure staff have an understanding of what types of information should be validated during investigations with independent parties such as the Financial Industry Regulatory Authority, Depository Trust Company, and Chicago Board Options Exchange.
  16. Include in its complaint handling guidance proper procedures for ensuring complaints received even if an investigation is pending closure, are properly vetted.
  17. Conduct periodic internal reviews to ensure that MUIs are opened in accordance with any newly developed Commission guidance and examine ways to streamline the case closing process. Enforcement should also ensure staff have adequate time in which to complete these types of administrative tasks.
  18. Put in place a process to periodically remind staff of their responsibilities regarding impartiality in the performance of official duties and instruct staff where they can find additional information regarding impartiality.
  19. Establish or utilize an existing working group to analyze the OIG survey information regarding staff concerns over communication of program priorities and make recommended improvements to the Director of Enforcement.
  20. Establish or utilize an existing working group to analyze the OIG survey information regarding staff concerns regarding case handling procedures within Enforcement and make recommended improvements to the Director of Enforcement.
  21. Establish or utilize an existing working group to analyze the OIG survey information regarding staff concerns over working relationships within Enforcement and make recommended improvements to the Director of Enforcement.

Robert Khuzami, Director of Enforcement, responded to the Inspector General’s report (The response is in Appendix IV of the report.) and concurred with all 21 recommendations.

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Schwarzman Stands up for Placement Agents

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“Eliminating placement agents as a group because there were a few bad actors who have tarnished the industry is analogous to eliminating Major League Baseball because several of its players behaved illegally.”

Steven Schwarzman, The Blackstone Group’s chairman and chief executive, has submitted a comment letter on the SEC’s proposed ban on placement agents interacting with public pensions.  He comes squarely down on the side of placement agents. In fact, he credits placement agents with being essential to his fund-raising success.

The proposed SEC rule is fallout from investigations by the SEC and the New York District Attorney into a pay-to-play scandal involving “fixers” and prior scandal in New Mexico

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SEC Announces New Division of Risk, Strategy, and Financial Innovation

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The Securities and Exchange Commission announced the creation of its new Division of Risk, Strategy, and Financial Innovation. University of Texas School of Law Professor Henry T. C. Hu will be its first Director. Professor Hu authored several articles that brought attention to potentially manipulative market practices using borrowed stock and derivatives.

“The new division combines the Office of Economic Analysis, the Office of Risk Assessment, and other functions to provide the Commission with sophisticated analysis that integrates economic, financial, and legal disciplines. The division’s responsibilities cover three broad areas: risk and economic analysis; strategic research; and financial innovation.”

But what is this new division going to be doing?

The new division will perform all of the functions previously performed by Office of Economic Analysis and Office of Risk Assessment, along with the following:

  1. strategic and long-term analysis
  2. identifying new developments and trends in financial markets and systemic risk
  3. making recommendations as to how these new developments and trends affect the Commission’s regulatory activities
  4. conducting research and analysis in furtherance and support of the functions of the Commission and its divisions and offices
  5. providing training on new developments and trends and other matters.

The SEC now has five divisions:

  • Division of Corporation Finance
  • Division of Enforcement
  • Division of Investment Management
  • Division of Trading and Markets
  • Division of Risk, Strategy, and Financial Innovation

According to Broc Romaneck, this is the first new division at the SEC since 1971. They divided Trading and Markets into Division of Enforcement and a Division of Market Regulation, and created a new Division of Investment Company Regulation, spun off from the Division of Corporate Regulation.

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New Compliance and Disclosure Intepretations for Regulation FD

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As part of the Updates to Compliance and Disclosure Interpretations, the SEC has published new compliance and disclosure intepretations for Regulation FD.

I found these CD&I’s particularly interesting in light of the SEC’s loss in the Cuban case. The SEC seems to be providing a better roadmap for disclosure of information.

Here are a few questions that caught my eye, with a snapshot of the answer. Go to the compliance and disclosure interpretations for Regulation FD for the full answer.

Question 101.03: Can an issuer ever review and comment on an analyst’s model privately without triggering Regulation FD’s disclosure requirements?

Answer: Yes. . .

Question 101.04: May an issuer provide material nonpublic information to analysts as long as the analysts expressly agree to maintain confidentiality until the information is public?

Answer: Yes.

Question 101.05: If an issuer gets an agreement to maintain material nonpublic information in confidence, must it also get the additional statement that the recipient agrees not to trade on the information in order to rely on the exclusion in Rule 100(b)(2)(ii) of Regulation FD?

Answer: No. An express agreement to maintain the information in confidence is sufficient. If a recipient of material nonpublic information subject to such a confidentiality agreement trades or advises others to trade, he or she could face insider trading liability.

Question 101.06: If an issuer wishes to rely on the confidentiality agreement exclusion of Regulation FD, is it sufficient to get an acknowledgment that the recipient of the material nonpublic information will not use the information in violation of the federal securities laws?

Answer: No. The recipient must expressly agree to keep the information confidential.

Question 101.09: Can an issuer disclose material nonpublic information to its employees (who may also be shareholders) without making public disclosure of the information?

Answer: Yes. Rule 100(b)(1) states that Regulation FD applies to disclosures made to “any person outside the issuer.” Regulation FD does not apply to communications of confidential information to employees of the issuer. An issuer’s officers, directors, and other employees are subject to duties of trust and confidence and face insider trading liability if they trade or tip.

Question 101.10: If an issuer has a policy that limits which senior officials are authorized to speak to persons enumerated in Rule 100(b)(1)(i) – (b)(1)(iv), will disclosures by senior officials not authorized to speak under the policy be subject to Regulation FD?

Answer: No. Selective disclosures of material nonpublic information by senior officials not authorized to speak to enumerated persons are made in breach of a duty of trust or confidence to the issuer and are not covered by Regulation FD. Such disclosures may, however, trigger liability under existing insider trading law.

Updates to Compliance and Disclosure Interpretations

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The staff of the Securities and Exchange Commission’s Division of Corporation Finance has updated a bunch of Compliance and Disclosure Interpretations.

Here are a few questions that caught my eye, with a snapshot of the answer. Follow the question’s link for the complete answer.

There are many more new and revised questions under the Securities Act Sections, Rules and Forms, Regulation S-K, Exchange Act Sections, Section 16 and Regulation FD.

Securities Act Sections

Question 103.04: Where the offer and sale of convertible securities or warrants are being registered under the Securities Act, and such securities are convertible or exercisable within one year, must the underlying securities be registered at that time?

Answer: Yes. . . .

Question 139.28: Must offers and sales be suspended during the waiting period of a post-effective amendment to an effective registration statement?

Answer: Offers and sales must be suspended if the post-effective amendment is filed for the purpose of a Section 10(a)(3) amendment and the prospectus is already stale for Section 10(a)(3) purposes. . . .

Securities Act Rules

Question 212.05: Can a registration statement under Rule 415 be declared effective without an opinion of counsel as to the legality of the securities being issued when no immediate sales are contemplated?

Answer: No. However, . . .

Securities Act Forms

Question 130.14: The Item-by-Item instructions for Item 7 of Form D indicate that an issuer must enter the date of the first sale of securities in the offering if the issuer is filing a “new notice.” If an issuer is filing an amendment to a Form D filing, must the issuer provide current information about the date of first sale in the amendment?

Answer: Yes. Rule 503(a)(4) provides that an issuer that files an amendment must provide current information in response to all requirements of the form, regardless of why the amendment is filed. For example, if, in the original Form D, the issuer indicated that the first sale has “Yet to Occur” and if, by the time of the amendment, the date of first sale is known, then the issuer must disclose the actual date of first sale in the amendment.

Regulation FD

This is an all new collection of CD&’s for Regulation FD.

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New SEC Rule on Political Contributions by Certain Investment Advisers

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The SEC has just published the text of the proposed rule on political contributions by investment advisers. SEC voted unanimously to propose this rule at its July 22nd Open Meeting.

http://www.sec.gov/rules/proposed/2009/ia-2910.pdf

The proposed rule is intended to curtail “pay to play” practices by investment advisers that seek to manage money for state and local governments.

The new proposed rule has four primary aspects:

1. Restricting Political Contributions

An investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation, either directly or through a fund.

The contribution prohibition would also apply to certain executives and employees of the  investment adviser.

Additionally, the range of restricted officials would include political incumbents and candidates for a position that can influence the selection of an adviser.

There is a de minimis exception that permits contributions of up to $250 per election per candidate if the contributor is entitled to vote for the candidate.

2. Banning Solicitation of Contributions

The proposed rule also would prohibit an adviser from coordinating, or asking another person or political action committee to:

  1. Make a contribution to an elected official (or candidate) who can influence the selection of the adviser.
  2. Make a payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government.

3. Restricting Indirect Contributions and Solicitations

There would be prohibition on engaging in pay to play conduct indirectly, if that conduct would violate the rule if the adviser did it directly. That would include directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser.

4. Banning Third-Party Solicitors

There is prohibition on paying a third party, such as a placement agent, to solicit a government client on behalf of the investment adviser.

SEC to Consider Pay to Play Rule for Investment Advisers

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At the SEC open meeting on Wednesday July 22, the Commission will consider whether to propose a rule to address “pay to play” practices by investment advisers. The proposal is designed, among other things, to prohibit advisers from seeking to influence the award of advisory contracts by public entities through political contributions to or for those officials who are in a position to influence the awards.

You can watch the meeting through the SEC Open Meetings Webcast, starting at 2:00 pm (EDT).

CCOutreach

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The SEC formed the CCOutreach (yes, that is how they spell it) to promote open communications and coordination among securities regulators and the industry on mutual fund, investment adviser, and broker-dealer compliance issues. In addition to the national seminar in November of each year, they host regional seminars to enable Chief Compliance Officers to interact with the staff from their local SEC office. I attended the Boston Regional CCOutreach seminar. These are my notes:

To start off, there was the usual SEC disclaimer: The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its staff. The views expressed by the staff in these written materials are those of the staff and do not necessarily reflect the views of the Commission or of other Commission staff.

The presentations started off with some interesting statistics (as of 12/31/2008):

  • 11,292 Registered Investment Advisers
  • 1,521 exams of investment advisers in 2008
    • 64% resulted in deficiency letters
    • 4% resulted in enforcement referral
  • 1,082 Registered Investment Companies
  • 219 exams of investment companies in 2008
    • 67% resulted in a deficiency letter
    • 5% resulted in enforcement referral

Rulemaking

The presentation continued by highlighting some of the current rulemakings in process: the amendments to Form N-1A, the principal trading rule, and amendments to Part 2 of Form ADV. They also noted two rulemakings that should be popping up soon. First is a proposed regulation on money market funds. This is largely in reaction to the issues with those types of funds last fall.The second is a likely rule making on pay to play issues.

Enforcement

The presentation moved on to three types of current enforcement actions, with recent enforcement cases as examples.

The first type is prominent fraud cases, using the SEC v. Robert Brown case as an example. This was a classic Ponzi scheme. The promoter promised astronomical returns, but really used the money to pay off early investors and to pamper himself. When confronted by investors, he claimed the delay in returning the money was due to the Patriot Act.

The second type is compliance failure cases, using the SEC v. Locke Capital case as an example. In this case, the adviser had less than $175 million, but claimed to have over $1 billion under management in order to gain credibility and attract legitimate investors.

The third type is prominent fund failure cases, using the Evergreen case as an example. Evergreen had a fund experiencing some gyrations due to its mortgage-backed securities holdings. The company put together some talking points for investors who called to complain or called with questions. That resulted in selective disclosure of a material piece of information. There were also issues related to failures in their valuation methods.

Fiduciary Duty

The presentation turned to fiduciary issues. A particular issue was how clients got out of positions. This is a reverse of  IPO investigations by the SEC. With IPOs, the SEC investigated whether some clients got preferred access to IPOs and how allocations of IPO shares were made to clients. With the all of the illiquidity in the market, the SEC is now focused on who was able to get out of those illiquid positions and whether some clients got preferred access to the exit.

There was some discussion of the Hennessee case where the SEC brought action for an investment adviser failing to conduct diligence. There seemed to be some split on the panel. Some saw the case as a failure of fiduciary duty. Others thought it was merely a failure to do what the firm advertised it did (subject investments to a vigorous due diligence review).

The presentation moved to what the SEC is looking at during a review. They emphasized that the first step is reviewing the marketing materials and disclosure documents. The SEC wants to understand the company’s business model before the review. They don’t do a cookie cutter review, but a customized review tailored to the company’s business model. The next step is looking at the deficiency letters, their recommendations and what the company has done in response. (You have a target on your back if you have a deficiency and have not done anything in response.)

The panel turned to companies with dual registrations. If you are wearing two hats, you have a heightened level of disclosure. The SEC does not want to regulate the business model, but they do want to make sure you are fair and equitable. Dual registration is commonplace and clients are comfortable with it. But conflicts seem unavoidable, so there is a heightened need for compliance and disclosure.

The focus shifted to proxy voting and the issues associated with it. The panel highlighted the Intech case where the company was subject to a proceeding for failing to sufficiently describe its proxy voting policies and procedures and failing to address a material potential conflict of interest. Intech decided to vote in accordance with AFL-CIO-based proxy voting recommendations for all clients’ securities at a time it was currying favor with the union for more investment business. The panel had a general consensus that it was not wrong to follow a voting model as long as it is fully disclosed.  The panel was split on whether Intech could have disclosed their way out the problem. Some panelists thought the conflict was too much.

Deficiencies

Things turned to problems and how a problem can morph from a disclosure to a deficiency to an enforcement. One of the panelists rattled off a list of factors:

  • Were there deficiency letters?
  • Did you fix the deficiency?
  • Did people raise issues and you ignore them?
  • How long was the problem going on?
  • Were clients harmed?
  • Was it intentional or inadvertent?
  • How far off was the disclosure?
  • Did the firm profit from the problem?

“There is a difference between candid disclosure and clever disclosure.”

Portfolio Management

In the area of portfolio management the SEC found found these to be the most common deficient practices:

  • Failure to adopt or maintain policies and procedures relating to its investment decision-making
  • Failure to maintain required books and records to corroborate investment decisions
  • Failure to disclose all conflicts of interest

In the current market turmoil “drift” is a hot topic. The panel focused on inadvertent drift versus intentional drift. Intentional drift is bad, putting clients into investments that do match up with their investment needs. The panelists acknowledged that this is a tough area. The key is to focus on the goal at the time of purchase of the investment. Then there needs to be a periodic review. Drift review is also difficult. You need to document specific requests by the client and update the investment objectives of the client.

Service Providers

Compliance officers need to review service providers since they are a risk factor according to the panel. In particular, you need to be attentive  to the existence of kickbacks or soft dollars. They panel went so far as to recommend running searches against email traffic for the possibility of communications about kickbacks. Another red flag for the SEC is frequently changing service providers.

Safeguarding Client Assets

The centerpiece for this part of the discussion was the new custody rule that has been published for comment: SEC Releases Proposed Custody Rules for Investment Advisers. The SEC plans to go directly to clients, custodian, counter-parties, and other third parties without notifying the investment adviser. They are expecting a custodian review to be a lengthy, time-consuming process. The surprise review must a surprise and must be a review of 100% of the assets. Sampling will not be permitted. The auditor must also be truly independent. They are going to look towards Regulation S-X for the definition of “independent.”

Performance Claims

It sounds like the SEC is going to look closely at performance claims, both for fraud in the claim itself and for the claim as an indication of underlying fraud. (Like Madoff‘s performance claims.)

The panel indicated an intent to look closely at how the performance numbers are calculated. A particular hot button is how illiquid and hard-to-value assets are included in the performance calculations. The SEC plans to run some forensics to see if there was some smoothing in the performance and whether the performance was too consistent or too good given the underlying assets in the portfolio.

In addition to the performance numbers themselves, the SEC is going to look closely at the disclosure wrapped around the performance claims. They want to make sure the disclosure and qualifications are consistent.

They are also going expect records to be kept to back up the performance claims. If you are claiming 20 years worth of results, you need to keep 20 years worth of records.

They emphasized the need to separate the valuation team from the portfolio management and marketing teams to get as much independence as possible. Using a third party custodian to value assets is probably acceptable, assuming there is no fraud or improper influences on the custodian.

Post-Mortem

The program was good and worth your time if you are a compliance officer for an Investment Adviser or Investment Company. I attended because I thought it best to meet and talk with people when you are in the position to offer them some help instead of needing them to help you. It seems that Congress wants the SEC to regulate private investment funds.

In the interest of full disclosure, the SEC gave out an inexpensive pen and a magnet with with SEC seal to attendees. I don’t think these “gifts” have influenced my decision-making about the SEC.

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SEC Implements New Compliance Program (On Itself)

After the embarrassing news that two of its attorneys are accused of insider trading, the SEC has decided to strengthen its internal compliance program to guard against inappropriate employee securities trading.

“It only makes sense that we have a world-class compliance program – just as we expect from those we regulate,” said Chairman Schapiro. “The employees at the SEC have a well-deserved reputation for integrity and professionalism. These measures will further bolster our standing by helping to prevent not only an actual impropriety, but the appearance of one as well.”

There are some common sense controls being put in place:

  • Employees must pre-clear all their securities transactions to ensure, among other things, the company whose stock they are trading is neither being investigated by the SEC nor is involved in an offering.
  • Prohibit ownership of securities in publicly-traded exchanges and transfer agents, in addition to existing prohibitions against owning securities in broker-dealers, registered investment advisers and others directly regulated by the SEC.
  • Require that all employees authorize their brokers to provide the agency with duplicate trade confirmation statements.
  • As part of the pre-clearance and compliance process, periodic reviews will be conducted by supervisors to compare transactions against the employee’s work projects to guarantee compliance with the rules.
  • A new computer system to automate employee reporting of personal securities transactions which would simplify the reporting process for employees and ensure accurate pre-clearance checks. (The new system would also provide for easy verification of transactions by comparing reported trades against confirmation statements provided directly by each employee’s brokerage firm.)
  • Consolidating the compliance and reporting responsibilities within the SEC’s Ethics Office. Previously, responsibility within the SEC for ensuring staff compliance was spread between two offices.

Insider Trading at the SEC

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A report from the SEC’s Inspector General has publicized that two attorneys at the Securities and Exchange Commission are under “active” criminal investigation by the FBI for trading stocks based on inside information. Bad news for an agency that is still under fire for missing the Madoff fraud.

Besides the salacious news, there are some items in the report that I think are interesting for a compliance professional.

According to some undated material, there was a thought in the early days of the SEC that its employees should not be permitted to trade in securities at all. That position was not finally adopted, but there is along history of limiting the ability of SEC employees to trade in securities. The restrictions are designed to ensure public confidence that Commission staff are not benefiting personally with respect to their information about securities. There is also an important need to prevent real and apparent conflicts of interest.

Rule Five of the Commission’s Conduct Regulation, 17 C.F.R. 200.735-5, contains the limitations applicable to all SEC Commissioners and employees. Some key limitations are:

  • Carrying securities on margin, purchasing securities with borrowed funds, and selling short
  • Purchasing securities of a company that to the employee’s knowledge is involved in current Commission investigations or proceedings
  • Purchasing or selling options, futures, or options on futures
  • Selling a security that has been held for fewer than six months

The SEC has a detailed reporting structure that employees must follow when buying and selling securities. It sounds like the structure doesn’t work.

“Our investigation revealed that the Commission lacks any true compliance system to monitor SEC employees’ securities transactions and detect insider trading. In addition, the OIG found that there is a poor understanding and lax enforcement of the Rule 5 reporting requirements.”

The SEC requires the investment advisers it regulates to have strict controls to avoid insider trading. It seems they lack the control themselves.

CBS News video story:

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