A Compilation of Enforcement and Non-Enforcement Actions

by Foley & Lardner LLP
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Non-Enforcement

  • Renewed Call for Investment Adviser User Fees
  • OCIE Director Repeats Concerns About Compliance Issues Found During Private Equity Adviser Exams
  • Will SEC Stick to Its Guns on Reg. A Plus Regulatory Authority?
  • Mutual Funds and Advisers Should Evaluate Oversight of Proxy Advisory Firms

Enforcement

  • Misusing Client Assets Results in Sanctions Against a Registered Investment Adviser

Non-Enforcement

Renewed Call for Investment Adviser User Fees

As we reported in previous editions of our Investment Management Newsletter, various persons have proposed that a user fee be imposed on SEC registered investment advisers in order to fund a more extensive examination program by the SEC.

The primary concern of the proponents of the imposition of a user fee is that registrants are not examined often enough by the SEC, due to SEC budget constraints. The SEC’s Office of Investor Advocate (the “Office”), a new office created under the Dodd-Frank Act, recently proposed that Congress provide the SEC authority to collect such fees from registrants. As part of its proposal, the Office stated each investment adviser could and should be examined at least every three years. In addition, the implementation of a user fee would permit the SEC the flexibility to examine “high-risk” registrants even more frequently. State securities regulators generally have the authority under their state securities laws to bill a registered investment adviser for the time and expenses of state examiners while conducting an examination of a registrant. The user fee being proposed upon SEC registrants could either impose a fee (like the states) subsequent to an examination or increase registration fees paid annually to cover the SEC’s examination program expenses.

This recent call for implementation of a user fee is one of several such calls over the last several years. Time will tell whether this recent call has traction in Congress.

OCIE Director Repeats Concerns About Compliance Issues Found During Private Equity Adviser Exams

Andrew J. Bowden, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) once again in a recent speech to industry representatives, described various areas of concern found by OCIE examiners during examinations of private equity advisers.

Those areas of concern include: (i) the use of confusing and/or incomplete limited partnership or limited liability company agreements regarding investor rights, (ii) valuation policies of the private fund assets are not fully explained within either the organizational documents or the private placement offering materials, and (iii) fees and expenses are not fully disclosed or are vague and open to interpretation. In addition, the OCIE has noted concerns when the general partner or manager of the fund has been found to have collected reimbursement for expenses from the fund when it should have paid for such expenses out of its own pocket.

Through his public announcements about the compliance concerns found by OCIE’s examiners, Mr. Bowden, in effect, serves as a warning to registrants that they should be addressing the type of concerns described by Mr. Bowden before the arrival of the OCIE examiners and possible enforcement action if such concerns are found to be present.

Will SEC Stick to Its Guns on Reg. A Plus Regulatory Authority?

The Jumpstart Our Business Startups Act (the “JOBS Act”) directed the SEC to come up with regulations to help revitalize the Regulation A registration exemption under the Securities Act of 1933 to allow offerings of up to $50 million (up from the current exemption limit of $5 million) without going through the SEC’s securities registration process.

The proposed regulations for Regulation A “Plus” offerings released last December by the SEC proposed, much to the disappointment of the North American Securities Administrators Association (“NASAA”), a framework in which state regulators would retain registration authority only over offerings under Reg. A to $5 million or less. NASAA, an organization consisting of the regulators of the 50 state securities laws, has been lobbying both Congress and the SEC since the SEC’s proposed regulations were released for public comment, to reconsider the proposed regulations and instead, have all Reg. A offerings under the state registration authority.

The state regulators have supposedly reworked a coordinated registration system among its members to collectively register such offerings so that they may be reviewed and approved by state regulators in a timely fashion. A good reason for not using the Regulation A exemption in the past by issuers was the fact that registration of the offering was required in each state that the offering would take place. Generally, state securities registration has been a confusing, costly and time-consuming process and to be avoided if at all possible. One of the chief reasons for the popular use by issuers of private placement offering exemptions under Regulation D is to avoid both state and federal registration requirements.

There are signs that the lobbying efforts by NASAA has gained some inroads with the SEC commissioners, and it is possible at this time that the final regulations will not include the preemption of state securities registration requirements for Reg. A Plus offerings (i.e., those Reg. A offerings from $5 million to $50 million).

Some securities lawyers continue to publicly support the SEC’s proposed state preemption in spite of the state securities regulators’ efforts to streamline the Regulation A Plus offering registration process. Securities lawyers who have experience in filing securities registration applications with multiple state securities regulators doubt that the states are collectively able to effectively streamline a process that in the past has been a material detriment to raising capital.

Only time will tell if the SEC changes its mind on Reg. A Plus offerings with respect to state preemption. The only thing for sure at this point is that NASAA members will continue to lobby the SEC commissioners in an attempt to keep from losing part of their regulatory turf.

Mutual Funds and Advisers Should Evaluate Oversight of Proxy Advisory Firms

The SEC has issued guidance regarding proxy advisory firms, in the form of 13 Questions and Answers, published in Staff Legal Bulletin No. 20 (“SLB 20”). The Staff’s guidance addresses, among other things, investment advisers’ responsibilities in voting client proxies and retaining proxy advisory firms. Such clients include mutual funds advised by an investment adviser.

In light of this guidance, mutual funds should re-evaluate their proxy voting policies and procedures and those of their investment advisers. In particular, mutual funds and advisers that use proxy advisory firms should carefully evaluate their oversight of such firms to ensure that they are complying with the SEC’s guidance.

As a fiduciary, an investment adviser owes its mutual fund clients a duty of care and loyalty with respect to proxy voting as well as other services undertaken on the client’s behalf. Further, Rule 206(4)-6 under the Investment Advisers Act of 1940 (the “Proxy Voting Rule”) provides that an investment adviser has an obligation to adopt and implement written policies and procedures that are reasonably designed to ensure that the investment adviser votes proxies in the best interest of its mutual fund clients.

SLB 20 provides guidance on an investment adviser’s responsibilities under the Proxy Voting Rule, including the following:

  • An investment adviser should review the adequacy of its proxy voting policies and procedures at least annually to confirm that they have been implemented effectively and continue to be in compliance with the requirements of the Proxy Voting Rule. In this regard, an investment adviser could demonstrate compliance with the Proxy Voting Rule by periodically sampling proxy votes to determine whether they complied with the investment adviser's proxy voting policy and procedures, or specifically reviewing a sample of proxy votes relating to proposals that may require additional analysis.
  • In most cases, mutual fund clients delegate all proxy voting authority to their investment advisers, the Staff clarified that the Proxy Voting Rule provides flexibility for an investment adviser and its client to determine the scope of the investment adviser’s proxy voting responsibilities. SLB 20 specifically notes that this may include, for example, arrangements where the adviser and its mutual fund clients determine: (1) that the time and costs associated with the mechanics of voting proxies with respect to certain types of proposals or issuers may not be in the client’s best interest; (2) that the adviser will abstain from voting any proxies; (3) that the adviser should vote proxies as recommended by the company’s management or in favor of all proposals made by a particular shareholder proponent; or (4) that the adviser will focus resources only on certain types of proposals depending on the client’s preferences.
  • In considering whether to retain or continue to retain a proxy advisory firm to provide proxy voting recommendations, an investment adviser should determine whether the firm has the “capacity and competency to adequately analyze proxy issues.” This could include consideration of the following factors: the adequacy and quality of the proxy advisory firm’s staffing and personnel; and the robustness of its policies and procedures regarding its ability to (1) ensure that its proxy voting recommendations are based on current and accurate information and (2) identify and address any conflicts of interest.
  • In addition, an investment adviser that has retained a proxy adviser must provide sufficient ongoing oversight in order to ensure that the investment adviser continues to vote proxies in the best interests of its mutual fund clients.
  • With respect to an investment adviser’s duties relating to the material accuracy of the facts upon which the proxy advisory firm’s voting recommendations are based, the Staff reiterated that an investment adviser that receives voting recommendations from a proxy advisory firm should determine that the proxy advisory firm has the capacity and competency to adequately analyze proxy issues, including the ability to make voting recommendations based on materially accurate information. If, for example, an investment adviser determines that a proxy advisory firm’s recommendation was based on a material factual error that causes the adviser to question the process by which the proxy advisory firm develops its recommendations, the adviser should take reasonable steps to investigate the error, and seek to determine whether the firm is taking reasonable steps to reduce similar errors in the future.

Enforcement

Misusing Client Assets Results in Sanctions Against a Registered Investment Adviser

The owner of a Washington state-based investment advisory firm was recently sanctioned by the SEC for multiple violations of the Investment Advisers Act of 1940, including the fraudulent use of client assets for his own personal use.

According to the SEC, Dennis H. Daugs Jr. and his firm, Lakeside Capital Management LLC used the funds ($3.1 million) of an elderly client without her permission in the form of a personal loan. In addition, Mr. Daugs used assets ($4.5 million) of a private fund his firm managed to make personal real estate transactions and to payoff clients who had threatened legal actions against him and his firm. The conduct apparently occurred during the period of 2008 to 2012. Although Mr. Daugs and his firm have paid back the funds fraudulently diverted from client accounts, they agreed to settle the enforcement matter with the SEC by paying more than $340,000 in disgorgement and interest to such clients, a $250,000 penalty to the SEC and Daugs will be barred from the securities industry for at least five years. The investment advisory firm will systematically cease operations and be dissolved under the monitoring of a third party.

The SEC’s allegations in the matter included violations by Mr. Daugs and his firm of the fraud provisions under both the Securities Exchange Act of 1934 and the Advisers Act, the custody rule, and the requirement to maintain written policies and procedures reasonably designed to prevent violations of the Advisers Act and its regulations.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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