A Compilation of Enforcement and Non-Enforcement Actions

by Foley & Lardner LLP
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Non-Enforcement

  • Advisers to Private Funds Among Targets of the SEC’s 2015 Examination Program
  • SEC Chair Discusses Mutual Fund Threats and Potential SEC Initiatives
  • SEC Regulatory Agenda Items for Mutual Funds

Enforcement

  • Investment Adviser’s Failure to Disclose Broker-Dealer Payments and Conflicts of Interest Leads to SEC Enforcement Action

Non-Enforcement

Advisers to Private Funds Among Targets of the SEC’s 2015 Examination Program

The U.S. Securities and Exchange Commission (SEC) recently announced the 2015 examination priorities for its Office of Compliance Inspections and Examinations (OCIE). Advisers to private funds should especially note that they are among the primary targets of OCIE’s 2015 examination program.

The OCIE’s exam priorities will reportedly focus on three primary areas: protecting retail investors (especially senior citizens), assessing market-wide risks, and using data analysis to locate signs of potential unlawful activity.

The list of priorities, according to the SEC, may be supplemented over the course of the year as determined necessary, and were compiled in collaboration with the SEC’s various divisions, regional offices, and other regulators.

With respect to the priority regarding the protection of retail investors, the OCIE examinations will focus on, among other things: “fee selection and reverse churning,” to determine if investors are being overcharged or are being placed in investments that serve the best interests of the broker or adviser, rather than the investor; “sales practices,” especially with respect to the recommendations by brokers or advisers to liquidate current holdings in retirement accounts to other investments that may not be suitable under the circumstances for the investor; “suitability,” when retirement assets are placed in investments that are too complex and/or afford excessive risk for the typical investor; and “alternative” investment companies, where investor funds are placed in non-registered investment companies, and the risks and lack of disclosure are an issue for investors.

Among the priority targets for OCIE’s examinations during the year will be registered municipal advisers, registered investment companies that have never been examined by the SEC, and advisers of private equity funds, primarily to determine the fees and expenses of such funds, and how they are allocated and disclosed to investors.


SEC Chair Discusses Mutual Fund Threats and Potential SEC Initiatives

In recent remarks, SEC Chair Mary Jo White discussed the SEC’s regulation of the asset management industry in relation to evolving markets and the attendant challenges. She noted that the SEC’s monitoring and regulation of conflicts of interest, as well as portfolio-composition and operational risks, must advance to address modern practices and new product offerings. The aim is not to eliminate all risk, Ms. White explained, but to regulate with an eye toward the balance of undue risks and rewards.

Key Takeaway: New SEC disclosure and reporting obligations may be forthcoming in the next year for mutual funds.

Summary: Ms. White explained that a focus on controlling risk is crucial. Mutual funds may encounter portfolio-composition risks, including liquidity and leverage, and operational risks involving inadequate processes and systems. Ms. White believes the SEC needs to enact a broader set of proactive initiatives to help ensure that the regulatory program is fully addressing these risks. To do this, she explained, the SEC must improve the quality of information used to study and respond to asset management risks and provide funds with the tools they need to identify and address risks associated with their portfolios. Ms. White went on to state that the SEC staff is in the process of developing enhancements for data reporting by both mutual funds and advisers to better inform the SEC’s risk-assessment activities. In connection with this, she noted that the SEC must ensure that registered funds have controls in place to identify and manage the risks of their increasingly diverse portfolios. A more comprehensive approach is needed, Ms. White stated, and the staff is considering whether broad risk management programs should be required for mutual funds and exchange-traded funds to address these concerns.


SEC Regulatory Agenda Items for Mutual Funds

The SEC’s semi-annual regulatory agenda includes several agenda items of interest to mutual funds. The publication of semiannual regulatory agendas by the SEC and other federal agencies is required by the Regulatory Flexibility Act, but does not have any binding effect. New agenda items of particular interest to the fund industry include the following:

  • Stress Testing for Large Asset Managers and Large Investment Companies: The Division of Investment Management is considering recommending that the SEC propose new requirements for stress testing by large asset managers and large investment companies.
  • Transition Plans for Investment Advisers: The Division of Investment Management is considering recommending that the SEC propose a new rule that would require investment advisers registered with the SEC to create and maintain transition plans.
  • Liquidity Management Programs for Funds: The Division of Investment Management is considering recommending that the SEC propose a new rule requiring open-end funds to adopt and implement liquidity management programs, and that the SEC provide enhanced guidance relating to required liquid assets in open-end funds.
  • Use of Derivatives by Investment Companies Under the Investment Company Act: The SEC previously issued a concept release requesting public comment on issues under the Investment Company Act raised by funds use of derivatives. The Division of Investment Management is considering recommending that the SEC propose new rules under the Investment Company Act addressing the use of derivatives by funds and related matters, including disclosure of fund use of derivatives.

Enforcement

Investment Adviser’s Failure to Disclose Broker-Dealer Payments and Conflicts of Interest Leads to SEC Enforcement Action

In a recent enforcement case, Shelton Financial Group, Inc. and Jeffrey Shelton, IAA Release No. 3993, a registered investment adviser and its sole owner, president, and chief compliance officer were found to have violated, among other provisions, the “anti-fraud” provisions under the Investment Advisers Act of 1940 (Advisers Act); this meant it failed to disclose to its clients’ and prospective clients’ compensation received by the advisory firm through an arrangement with a broker-dealer, thereby steering the adviser’s client investments into certain mutual funds managed by the broker-dealer’s affiliates.

According to the SEC’s complaint, the arrangement between the advisory firm and the broker-dealer commenced in 2008, and the adviser received payments from the broker starting in 2009. Until 2010, the adviser failed to disclose to clients and prospective clients the payments it received from the broker and the inherent conflict of interest associated with such payments. Part 2A of Form ADV (Item 14.A.) requires the disclosure by the investment adviser to clients and prospective clients of payments received from third parties, the resulting conflicts of interest, and how the investment adviser addresses such conflicts.

Finally in 2011, the adviser made an attempt to disclose the payments within its disclosure part of Form ADV, but did not fully disclose the payments under the broker agreement and the conflicts of interest with respect to the adviser, choosing the particular broker-dealer with whom it had the payment arrangement. Apparently, full disclosure of the payments and discussion about the conflicts of interest within the adviser’s Form ADV was not achieved until after the SEC had brought it to the attention of the adviser during a SEC examination.

The violations cited by the SEC in its complaint included the “anti-fraud” violations and failure to have and implement written policies and procedures reasonably designed to prevent such violations as required under the Advisers Act.

In determining the sanctions to levy against the adviser and its principal with respect to the violations under the Advisers Act, the SEC stated that it took into account the remedial acts promptly implemented by, and with the cooperation of, the adviser and its principal with the SEC.

In order to conclude the SEC’s enforcement action, among other things, the adviser agreed to: retain an independent compliance consultant to review the adviser’s policies and procedures, and make a full report to the SEC indicating the steps that have been taken by the adviser to prevent and detect similar violations; employ, for a period of five years, a chief compliance officer who is not an employee or officer of the adviser; the issuance of an SEC cease and desist order and an order of censure; the payment of disgorgement with interest of about $120,000, and of a civil penalty in the amount of $70,000.

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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