SEC Finds More Undisclosed Conflicts, Robo-Advisors Advertising Missteps and More 12b-1 Fee Cases: Lessons Learned from Recent SEC and FINRA Cases for February 2019


SEC Cries Foul for Failure to Disclose Private Equity Fund Expense Allocation Practices:  The SEC fined private fund manager, Lightyear Capital, $400,000 for making its private funds pay costs and expenses without making its employee funds and co-investors bear their fair share.  Lightyear managed four private equity funds, its “Flagship Funds,” and three “Employee Funds” that allowed its employees to invest alongside the Flagship Funds.  Lightyear also allowed co-investors to participate in the acquisition of some portfolio companies purchased by the Flagship Funds.

The Flagship Funds’ organization documents disclosed that certain expenses, such as legal, consulting, insurance and broken deal expenses, would be paid with fund assets.  What annoyed the SEC was that Lightyear did not disclose that the Employee Funds did not pay their share of these fees despite receiving the benefits of these services and investing alongside Flagship Funds.  Similarly, co-investors invested alongside the Flagship Funds and did not pay a proportional share of post-closing expenses.  Again, the SEC slammed Lightyear for not disclosing this practice to the Flagship Fund investors.  Lightyear also received fees from portfolio companies in the Flagship Funds, which were used to offset the management fees paid by the funds.  Lightyear had agreements to share some of these fees with some of its co-investors.  Again, this practice was not disclosed to Flagship Fund investors, who did not receive the benefit of a greater offset to the fund management fees as a result of this fee-sharing arrangement.

This case is just another in a long line of enforcement actions against private equity managers for failures to disclose conflicts of interest.  The lesson learned is that although the disclosure in your offering documents may be accurate, it might not be complete.  Side-by-side management and fee sharing arrangements are traditional areas of conflicts and should be scrutinized for potential negative effects on clients and investors.  Contributed by Jaqueline Hummel, Partner and Managing Director

Plus Ça Change, Plus C’est La Même Chose: Robo-Advisers and Advertising Issues:  Hedgeable, Inc. (“Hedgeable”) and Wealthfront Advisers LLC (“Wealthfront”) ran afoul of the anti-fraud provisions and advertising rules under the Advisers Act.  The SEC found that both firms engaged in misleading advertising practices and making false statements.  Hedgeable presented better-than-average composite returns as compared to a custom index of two competitor firms.  However, the SEC found that the composite reflected less than 4% of Hedgeable’s client accounts, and the custom index returns were based on approximations rather than actual returns of trading activity by the competitors.  The SEC also found errors in the adviser’s return calculations, insufficient oversight, and a lack of supporting documentation.  Wealthfront published a white paper to its website describing its tax loss harvesting program, including a proprietary process to monitor taxable accounts to avoid wash sales.  In fact, the SEC found that Wealthfront did not monitor program accounts for wash sales for the three years the white paper was available, and as a result, more than 30% of program clients experienced wash sales.  Wealthfront also retweeted comments made by clients which constituted prohibited testimonials and compensated referral sources without sufficient disclosures and documentation as required by the cash solicitation rule.  Both firms agreed to censure and Hedgeable’s and Wealthfront’s penalties were $80,000 and $250,000, respectively.

Although it’s noteworthy that these enforcement actions mark the first against robo-advisers, the compliance issues raised are broadly applicable.  All advisors benefit from well-developed policies and procedures for calculating and reporting performance that include proper documentation and supervisory reviews and approvals.  Similarly, advisers should evaluate their process for preparing white papers, RFPs, and due diligence questionnaires with the goal being a final product that is accurate and does not contain misleading information, including descriptions of sometimes technical and nuanced services or functionality.  Contributed by Cari Hopfensperger, Senior Compliance Consultant

12b-1 Enforcement Continues:  In an all-too-familiar story, investment adviser representatives (IARs) for American Portfolios Advisors Inc. (“Advisory Portfolios”) and PPS Advisors Inc. (“PPS”) received 12b-1 fees from mutual fund investments in certain share classes (primarily class A shares) when lower cost share classes (primarily class I shares) of the same funds were available to their clients through wrap programs sponsored by the firms.  The SEC found that both firms failed to disclose related conflicts of interest, violated their best execution responsibilities, and lacked sufficient policies and procedures for share class selection.  According to the SEC’s findings, both firms’ disclosures directly contradicted actual practices employed by IARs, rather than suffering from an inappropriate use of the word “may,” as has been the SEC’s findings in similar enforcement actions.  The Form ADV Part 2B for the IARs also lacked disclosure related to the 12b-1 compensation they received.  PPS lacked written policies and procedures while American Portfolios had, but did not implement them.  Together, penalties for both firms (including a separate action against PPS’ CEO/CIO) totaled over $1.8 million.  The SEC noted that both firms had been contacted by the SEC about these violations before the launch of last summer’s SCSD Initiative, so they were ineligible to participate.

The SEC order stated that American Portfolios had $6.2 billion in assets under management and 200+ IARs, while PPS had just over $350 million, approximately 10 IARs, and it ceased advising clients, withdrawing its SEC registration in March 2018.  According to American Portfolios’ most recent Form ADV, it appointed a new CCO in January 2018.  Large or small, the monetary and reputational impacts of these enforcement cases on advisers are significant, especially in this high-profile initiative.  Advisers facing this conflict must take great care when crafting related disclosures and implement robust share class section policies and procedures in line with those disclosures.  Firms should conduct initial and periodic training, so employees understand these procedures.  Compliance officers should also follow up with testing to determine whether there is a disconnect between practices and disclosures over time.  Contributed by Contributed by Cari Hopfensperger, Senior Compliance Consultant

Worth Reading  

For 2019: 10 Takeaways from the Country’s Seniors Laws:  Bressler Amery Ross provides some important stats for RIAs and BDs.

The SEC on Rollovers – The Agency says RIAs are Fiduciaries:  Fred Reish and Joan Neri talk about SEC expectations when it comes to IRA rollovers.

Private Funds Regulatory Compliance Calendar 2019: Awesome planning tool for private funds and advisers by Paul|Weiss.

Guardians of the (Compliance) Galaxy: Lessons from SEC and FINRA Enforcement Actions Against Compliance Officers (December 2017 to September 2018): I need a hero![1]  Eversheds Sutherland published this super-hero spin on enforcement lessons for brokers and advisers.

What’s Good for the Goose: Protecting against Vendor Cybersecurity Risk: Peri N. Mahaley of the Pillsbury Policyholder Pulse Blog provides practical considerations to help firms evaluate the cybersecurity risk associated with vendor relationships.

2019 Ethics and Compliance Predictions: Michael Volkov outlines key compliance topics for 2019.  First up for Mr. Volkov – an ethical culture: “As a pure economic matter, an ethical culture is the most cost-effective control that a company can implement.”

Remedies and Relief in SEC Enforcement Actions: A glimpse behind the curtain of SEC Enforcement as presented in Oct. 2018 in a speech by Steven Peikin, Co-Director, Division of Enforcement.

2018 Review: SEC Continues Active Oversight of Registered Private Fund Managers: Kirkland & Ellis shares their retrospective on 2018 with an eye to the future.

[1] Copyright credit: Bonnie Tyler

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