Advisers Fall Short on Referral Arrangements, Mutual Fund Exams Planned, Updates to Annual and FOCUS Reports Finalized: Regulatory Update for December 2018

Hardin Compliance Consulting LLC

For Investment Advisers: SEC Actions

Risk Alert – Investment Adviser Compliance Issues Related to the Cash Solicitation Rule: The Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert with a list of top deficiencies under Rule 206(4)-3 (the “Cash Solicitation Rule”) of the Investment Advisers Act.  The biggest problems?  Failing to have a referral agreement in place, and either failing to give disclosure to clients about the arrangement or failing to have signed proof from clients that they received the disclosure. Check out our blog post for in-depth advice on avoiding Cash Solicitation Rule pitfalls.   Contributed by Jaqueline Hummel, Partner and Managing Director

SEC Enforcement Division Issues Report on FY 2018 Results: The Securities and Exchange Commission’s Enforcement Division issued its Annual Report, stressing the five qualitative principles it uses to assess its performance as well as providing quantitative data results.  They continue to emphasize that protecting retail investors is their highest priority.

The five principles include:

  1. Focus on Main Street Investors- The Division created two initiatives in 2018, the Retail Strategy Task Force and the Share Class Selection on Disclosure Initiative to protect retail investors.
  2. Focus on Individual Accountability- The Commission charged individuals in more than 70% of the stand-alone enforcement actions with a concentration on CEOs and CFOs.
  3. Keep Pace with Technological Change- The Cyber Unit became fully functional in 2018 and became a leader in addressing misconduct relating to digital assets and initial coin offerings.
  4. Impose Remedies that Most Effectively Further Enhancement Goals- The Division used creative techniques to supplement financial remedies to address underlying charges. In one example, the Commission’s settlement stripped a CEO of her super-majority voting control and ensured she would not benefit from a future sale or liquidation until shareholders were made whole.
  5. Constantly Assess the Allocation of Our Resources- The Division shifted its limited resources (headcount is down 10% since 2016) into market segments with emerging risks and was also pragmatic regarding its case selection.

To summarize the quantitative effects of its activity in 2018, the Division issued 821 enforcement actions, returned $794 million to investors, received $3.945 billion in disgorgement and penalties, suspended 280 companies and issued 550 individual bars and suspensions. It’s also worth noting that enforcement actions in Securities Offerings and Investment Advisers /Investment Company led the list at 25% and 22%, respectively.  Contributed by Heather Augustine, Senior Compliance Consultant

For Broker-Dealers:  FINRA Actions 

BDs and RIAs, Mark Your Calendars for December 17, 2018:  Log into your E-Bill account and review your 2019 Preliminary Renewal Statement.  Payment-in-full is due Monday, December 17th!  There are many payment options available.  Late fees will be assessed.   Don’t forget, certain jurisdictions (such as Illinois) may require additional documentation to be submitted directly to their office.  Please refer to the NASAA Regulator directoryContributed by Rochelle Truzzi, Senior Compliance Consultant

SEC Approves Amendments to the Financial Reporting Requirements impact FOCUS and Annual Audit Requirements:  Broker-dealers should be aware that these amendments apply to FOCUS reports and Annual Audit Reports filed for the period ending January 31, 2019 and after.  FOCUS reports have been updated to reflect GAAP requirements. The Statement of Financial Condition and the Statement of Income will include new line items to report details of comprehensive income and will eliminate references to extraordinary gains/losses and the cumulative effect of changes in accounting principles.  The Annual Audit report must contain a Statement of Comprehensive Income, in place of a Statement of Income, where comprehensive income exists in the reporting period.  Contributed by Rochelle Truzzi, Senior Compliance Consultant

Heads-up BDs – Regulation NMS Amended to Require Additional Disclosures on Order Handling:   Beginning in June of 2019, Rule 606 of Regulation NMS will require broker-dealers to provide, at the request of a customer who places not-held orders (firm has price and time discretion), certain individualized disclosures regarding the handling of the customer’s orders.  The new and enhanced disclosures are intended to provide the customer with a better understanding of how their firm routes their orders so that the customer can evaluate the execution quality of such orders.  Exceptions to the Rule are available at both the firm and customer levels.

In addition, the quarterly public reports required under Rule 606 will cover NMS stock orders of any size that are submitted on a held-basis and will require information to be reported in a new manner.  The quarterly public reports on order execution and routing, required by Rules 605 and 606, must be free and posted on a website readily accessible to the public for a period of three years.

Introducing firms should discuss the implementation process with their clearing firms.  The Rule amendments become effective on January 18, 2019, with a compliance date of June 18, 2019.  Contributed by Rochelle Truzzi, Senior Compliance Consultant

For Mutual Funds: SEC Actions 

OCIE Risk-Based Exam Initiatives for Investment Companies:  In a continued focus on retail investors, OCIE announced new exam initiatives applicable to certain investment companies in a Risk Alert.  The alert highlights the types of funds and key areas of interest OCIE will be exploring during these exams.

OCIE is interested in the following types of funds: smaller, low trading volume ETFs; index funds tracking custom indexes; mutual funds with underperformance relative to peer groups or have high allocations to securitized assets (such as certain securitized loans, credit card receivables, or mortgage-backed securities).  OCIE is also looking at advisers that are either new to mutual funds or that provide ‘side-by-side’ advice to mutual funds and private funds. Based on the Risk Alert, funds and advisers selected for examination should expect the Staff to dig into whether risks and conflicts are appropriately reflected within fund and adviser policies and procedures, and disclosed to shareholders and fund boards. OCIE will also be reviewing the evaluation and oversight processes used by funds, advisers and fund boards to mitigate their risks and conflicts.

Finally, OCIE proactively shared what it views as the material risks and key areas of exam focus unique to each type of fund in scope – with emphasis again placed on the potential for harm to retail investors.  Advisers to mutual funds cited in the alert should address the conflicts discussed in the Risk Alert as part of the firm’s annual compliance program review, risk assessment and testing program.  Contributed by Cari Hopfensperger, Senior Compliance Consultant

Investment Company Reporting Modernization Frequently Asked Questions:  The SEC recently updated its FAQs related to the Investment Company Reporting Modernization Act reforms.  Most relevant to advisers will be information related to Form N-PORT and N-CEN, though the FAQ also addresses Regulation S-X.  Given the phased approach to implementation and the amendments adopted, funds are encouraged to use this resource to help interpret and understand the requirements and timelines that apply to their specific circumstances.  Contributed by Cari Hopfensperger, Senior Compliance Consultant

Save some Trees!  Optional Internet Availability of Investment Company Shareholder Reports:  Funds interested in taking advantage of the new option for internet delivery of mutual fund shareholder reports under the SEC’s Rule 30e-3 may wish to re-visit our write up on the topic, given the Rule’s effective date of January 1, 2019.  Although the earliest that shareholder reports may be delivered online is January 1, 2021, the Rule requires that funds prominently disclose their intent to pursue online delivery in summary and statutory prospectuses, and the annual and semiannual reports for two years beforehand.  Interested funds and their advisers may wish to raise the topic with fund administrators to evaluate their plans to facilitate this option and the expected costs.  Contributed by Cari Hopfensperger, Senior Compliance Consultant

For Hedge Fund Managers: 

CFIUS Establishes Critical Technology Pilot Program – Impacts on Investment Funds: The Department of Treasury released interim rules in mid-October establishing a pilot program (the “Pilot Program”) that requires parties to notify the Committee on Foreign Investment in the United States (CFIUS), prior to closing, of certain foreign investments in US business involved in “critical technologies” within 27 specified industries.  This is the first mandatory filing requirement imposed by CFIUS.  The rule implements portions of the Foreign Investment Risk Review Modernization Act (FIRRMA), meant to address national security concerns resulting from foreign investments in U.S. companies.  Applicable transactions are subject to mandatory reporting to CFIUS for a review of their potential impact on national security.  The pilot program runs from November 10, 2018 through March 5, 2020, and filings, when warranted, will be required 30-45 days in advance of the transaction, depending on the type of filing being made.

The Pilot Program applies to foreign investments in U.S. businesses that “produce, design, test, manufacture, fabricate or develop one or more critical technologies.”  The program applies to 27 industries identified by their classifications under the North American Industry Classification System Code and includes a wide range of industries including not only those that have obvious national security applications, but many others such as power distribution, battery manufacturing, nanotechnology, biotechnology, and wireless equipment manufacturing.

Investments subject to the pilot program include those where a foreign investor has “(i) access to material nonpublic technical information held by the Pilot Program U.S. Business; (ii) membership or observer rights on the board of directors or similar governing body of the Pilot Program U.S. Business; or (iii) the right to appoint a member of the Pilot Program U.S. Business’ board of directors; or (iv) any involvement, beyond the mere voting of shares, in substantive decision-making regarding the Pilot Program U.S. Business.”  (See text of Interim Rule)

Passive investments by foreign persons in U.S. managed investment funds are generally exempt from requirements of the pilot program, provided that the foreign person does not generally have the ability to control the fund or the investment decisions of the fund manager, or have access to material nonpublic technical information of the U.S. business covered by the Interm Rule.

While the Interim Rule includes practical examples, the applicability of the pilot program to a US fund manager with foreign investors investing in the covered industries depends on several nuanced definitions in the Interim Rule.  Penalties for noncompliance can be steep and include a civil monetary penalty up to the value of the transaction, or require the unwinding of the transaction.  See the decision flowchart in this informative article and the CFIUS Critical Technology Pilot Program Fact Sheet for additional details.  Contributed by Cari Hopfensperger, Senior Compliance Consultant

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Hardin Compliance Consulting LLC

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