Lessons Learned from SEC & FINRA Cases and Worth Reading for September 2020

Lessons Learned

Another Private Equity Firm Nailed for Overhead Expense Allocation Issues. Rialto Capital Management, a private equity firm to real estate private funds and related co-investment vehicles, employed an expense reimbursement practice by which it performed certain services for the funds that are usually performed by external service providers (described here as “Third-Party Tasks”). The fund’s operating documents then permitted Rialto to reimburse itself for performing those tasks, following approval by each fund’s Advisory Committee.

Rialto was found to have misallocated a disproportionate share of Third-Party Task expenses to the Funds over the review period, where more should have been paid by the co-investment vehicles. Additionally, when seeking approval from the Advisory Committees, Rialto failed to provide sufficient disclosure of increases to the rates of overhead expense over time and evidence to support a statement that the services were “at or below” market rates, as required by the fund operating documents. Finally, the SEC found the adviser’s policies and procedures to ensure proper calculation, allocation and disclosure of these costs and expenses.

SEC scrutiny of the practices used by funds to calculate, allocate and disclose fund expenses continues to escalate. This is especially true for firms with co-investment vehicles and that reimburse themselves for internally provided services to their own funds. Firms with these elevated risks should take extreme care to ensure that disclosures are thorough and appropriate, that procedures to calculate and allocate those expenses are robust, that proper governance and controls are in place, and that they are tested properly to confirm compliance. Contributed by Cari A. Hopfensperger, Senior Compliance Consultant.

Advisers Punished for Not Telling the Whole Truth. The SEC expects “the truth, the whole truth, and nothing but the truth” from investment advisers. WBI Investments, Inc. (“WBI”) and Millington Securities, Inc. (“Millington”) both SEC-registered investment advisers found this out the hard way. WBI and Millington provide advisory services to a series of ETFs and mutual funds (the “Funds”), and WBI made the investment decisions for these shared clients, while Millington acted as an introducing broker for WBI since it was also registered as a broker-dealer. Millington routed trades for the Funds to a group of broker-dealers for execution, the “Executing Brokers.” Millington did not charge WBI or the Funds commissions for its brokerage services but still profited from the trading activity, and that’s where the trouble starts. The Executing Brokers paid Millington a flat fee per share for executing trades for WBI’s clients, a practice known as “payment for order flow”. WBI and Millington told their clients, including the Funds, not only that they received payments for order flow, but that these payments did not affect the prices at which the clients’ orders were executed. Millington received approximately $7.6 million in order flow payments over the course of the arrangement.

But wait, there’s more. As part of Millington’s deal with the Executing Brokers, Millington agreed that the brokers could execute trades for WBI clients on a “net pricing” basis. Here’s how it worked: after receiving orders from Millington, the Executing Brokers would buy the securities in the market and sell them to Millington at a mark-up, known as the “net price.” The Executing Brokers kept the difference between the market price and the net price as compensation for effecting the trade, and WBI’s clients paid the net price. Over time, Millington and the Executing Brokers agreed to specific net pricing designed to compensate the Executing Brokers for the order flow payments and provide them with some profit for executing the trades.

So ultimately WBI’s clients, including the Funds, were paying higher than market prices for their trades. This was a problem, according to the SEC, because WBI and Millington told their clients, including the Funds’ Board of Trustees, that the payment for order flow did not have a negative impact on the price of securities traded for WBI’s clients. Millington and WBI had to pay penalties of $250,000 and $750,000, respectively, for making “materially misleading statements” in violation of Section 206 of the Advisers Act (the anti-fraud provision).

What is interesting about this case is that there was no discussion of whether the Funds would have been better off paying commissions instead of engaging in this payment for order flow/net pricing arrangement. Instead, the Commission focused on the lack of disclosure about how the order flow payments were connected to net pricing. Advisers should be careful to “tell the whole truth” when disclosing arrangements that result in significant revenue to affiliated entities. Although the SEC does not come out and say it, the $7.6 million payment received by Millington may have influenced its decision to bring this case. Contributed by Jaqueline M. Hummel, Partner and Managing Director.

The Hidden Risks of Trade Allocation Practices. As compliance professionals, we strive to ensure our policies and procedures, disclosures and agreements adhere to the fiduciary standard imposed by the SEC under Investment Advisers Act of 1940. However, there are times when it is not obvious that clients are not being treated fairly when allocating securities to multiple client accounts. In the case of Birinyi Associates, the SEC laid bare the inequality of the firm’s allocation policy as applied to its “Day Trade” and “Buy and Hold” Clients. “Buy and Hold” clients formed the majority of the firm’s client-base, while a smaller number were “Day Trade” accounts where clients directed Birinyi to sell at the end of each day.

Like many firms, Birinyi used a master account at a third-party broker to execute block trades and then allocate those trades to their client accounts according to its pre-trade decisions. Birinyi would monitor block orders and if a purchase was profitable that day the firm would sometimes sell off the purchased security that same day and then allocate the trades to its Day Trade Clients, contrary to its pre-trade determinations. The SEC stated that “through this allocation process, the Day Trade Clients were subject to risk-free profits where the Buy and Hold Clients bore all the risk.” The Buy and Hold clients did not benefit from the first day returns.

Birinyi argued that over the long term, the Buy and Hold Clients “earned significantly higher-than-average annual returns during the Relevant Period than the Day Trade Clients”. However, the SEC disagreed. “The trades that Birinyi Associates allocated to the Day Trade Clients during the Relevant Period earned an average first-day return of 0.26%. By comparison, the trades allocated to Buy and Hold Clients during the Relevant Period had an average first-day return of −0.02%.” The SEC did have mercy on Birinyi and only fined the firm $100,000 and required it to hire a third-party compliance consultant to update its policies and procedures and disclosure documents. Advisers are reminded to have checks and balances in place whenever an allocation deviates from the pre-trade determination. But, the critical take-away is that long-term results are not the only criteria to use when reviewing allocation practices and testing client accounts. The firm must also consider short-term results and risk. Contributed by Heather A. Augustine, Senior Compliance Consultant.

Worth Reading

SEC Share-Class Crackdown Could Spell the End for 12b-1 Fees. Mark Schoeff Jr., from Investment News, offers perspective on the recent SEC enforcement action against SCF Investment Advisers for share class selection violations and what it may signal to the investment community.

SEC Staff Announces Examination Initiative on LIBOR Transition Preparedness. Jones Day summarizes the SEC’s new focus on LIBOR readiness by broker-dealers, investment advisers and investment companies. It also highlights several questions firms should expect from the SEC in upcoming examinations. In addition to this helpful article, the SEC attached a list of 20 possible questions to the risk alert itself. For more on this topic, see “Broker-Dealers: Prepare for LIBOR Phase-Out” by Rochelle Truzzi above and the August issue of Compliance Informer.

IAA 2020 Compliance Testing Survey Results Released. This annual survey of nearly 400 firms reviews a wide variety of RIA investment management compliance testing practices. Encouragingly, the “vast majority” of firms reported they were not materially impacted by the COVID-19 pandemic. Almost 80% do not plan to make material updates to their BCP as a result of COVID-19; however, almost 70% of firms’ BCPs already addressed pandemic response plans. Unsurprisingly, BCP overtook Cybersecurity’s six-year run as the year’s hot topic. Check out the results for more interesting insights.

How One Person Can Change the Conscience of an Organization. Step outside of typical compliance topics and consider this inspiring article from the Harvard Business Review. It draws from leadership experience in pharmaceuticals and global healthcare to highlight universal ways that an employee at any level of an organization can become a catalyst for positive change – lessons that are instrumental for any compliance professional.

Ten Tips for Navigating Risks and Liability at Portfolio Companies During COVID-19. Proskauer’s Coronavirus Response Team notes that the COVID-19 pandemic has contributed to an increase in litigation associated with portfolio companies and offers these tips to help fund sponsors identify and mitigate risks as well as inform directors.

Shed the Shame: Taking a PPP Loan Is Not What You Think. Kirsten Plonner offers this ThinkAdvisor editorial on PPP Loans as the industry continues to process the implications of accepting them.

Photo Credits: Photo by Domenico Loia on Unsplash.

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