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


Lessons Learned

Franklin Advisers / Franklin Templeton. A July proceeding against Franklin Advisers, Inc. (“FAV”) and Franklin Templeton Investments Corp. (“FTIC”) (together, “Franklin”) serves as a reminder to mutual fund advisers that even low-risk violations can come back to haunt them when chronically ignored. Section 12(d)(1) of the Investment Company Act (the “Fund of Funds Rule”) prohibits investment companies from (1) acquiring more than 3% of the outstanding voting stock of another registered investment company (“RIC” or “mutual fund”); (2) putting more than 5% of total assets into a single RIC; and (3) putting more than 10% of their total assets into RICs generally. Section 12(d)(1)(F) allows a fund company to exceed these limits with the caveat that the company and its affiliates do not own, in the aggregate, more than 3% of the outstanding shares of the acquired company.

During 2014 and 2015, certain Franklin funds acquired shares of three unaffiliated ETFs, with each fund exceeding its own 10% limit on RIC holdings. While the SEC noted that the funds had written policies and procedures designed to ensure Section 12(d)(1) compliance, FAV failed to implement a pre-trade screening process to prevent breaches. Compliance eventually discovered the breaches, and FAV reduced its ETF positions to correct them, realizing a loss in one of the three correcting trades. Because the other two sales resulted in gains that more than offset the loss, FAV concluded that the losses need not be reimbursed, creating a conflict of interest that FAV failed to disclose. FAV also failed to share its decision not to reimburse the funds for their losses with the fund board, only doing so after the commencement of the SEC’s investigation in February of 2018.

The SEC charged both Franklin entities for breaching the limits of Section 12(d)(1). FTIC was charged a penalty of $75,000. FAV was also charged with failing to implement policies and procedures as required under Investment Advisers Act Section 206(4), and Rule 206-4(7), the Compliance Program Rule), and hit with a $250,000 fine.

The takeaway here is that mutual fund advisers should maintain robust pre-trade and post-trade compliance procedures to monitor compliance with portfolio guidelines, whether they are driven by the Investment Company Act, IRS rules, or the mutual fund’s prospectus. If and when errors occur, fund advisers should be transparent in their reporting to the board. Finally, netting gains from one trade error against a loss from another to avoid reimbursing a client account for the loss on the error is problematic. Contributed by Mark L. Silvester, Compliance Associate.

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Photo Credits: Photo by timJ on Unsplash.

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