In December 2016, then acting Chairwoman of the Securities and Exchange Commission (“SEC”) Mary Jo White drafted a proposal that, if adopted, would enable third-parties, such as private sector organizations, to perform compliance exams of investment advisers.  Chairwoman White drafted this proposal in order to “increase SEC oversight of the approximately 11,800 registered investment advisers.”  In 2016, the SEC conducted evaluations of only 11% of all registered investment advisers.

However, Michael Piwowar, the current SEC Chairman, has expressed opposition to the proposal.  Piwowar claims that allowing third parties to conduct investment adviser exams would not increase the SEC’s efficiency because the SEC would still be required to monitor the third parties that it hires to conduct the exams.  He is also of the opinion that requiring SEC employees to conduct the exams would better enable the SEC to become aware of “trends in the industry.” Continue reading

On February 2, 2017, the Securities and Exchange Commission (“SEC”) filed a complaint in the United States District Court for the District of Connecticut against Sentinel Growth Fund Management, LLC (“Sentinel”), an investment adviser, and its founder, Mark J. Varrachi (“Varrachi”).  The complaint alleges that from about December 2015 to November 2016, Varacchi and Sentinel stole $3.95 million or more from investment advisory clients.  The complaint asks that the District Court impose a permanent injunction against Varacchi and Sentinel, order them to disgorge any ill-gotten gains, and order them to pay civil penalties.

Neither Sentinel nor Varrachi was registered as an investment adviser with the SEC or with any state regulatory authority.  However, the SEC charged both of them with violations of the Investment Advisers Act of 1940 (“Advisers Act”).  The SEC found that Sentinel was “in the business of providing investment advice concerning securities for compensation,” which fits the definition of an investment adviser in Section 202(a)(11) of the Advisers Act.  As for Varrachi, the SEC determined that because he owned and managed Sentinel, he too was an investment adviser.  As a result of meeting the definition of an investment adviser, Sentinel and Varrachi were subject to the Advisers Act’s antifraud provisions. Continue reading

In February 2017, the Financial Industry Regulatory Authority Inc. (“FINRA”) published a Regulatory Notice asking for comment on proposed changes to FINRA Rule 2210, which governs communications with the public.  Under current Rule 2210, broker-dealers are not allowed to make communications that “predict or project performance, imply that past performance will recur or make any exaggerated or unwarranted claim, opinion or forecast.”  According to FINRA, the purpose of this rule is to prevent retail investors from relying on performance projections relating to individual investments, which tend to be deceptive.

However, FINRA has acknowledged that performance projections that are not based on how well an individual investment performed can be helpful to investors who are contemplating an investment strategy.  Furthermore, investment advisers are permitted to use performance projections in choosing an investment strategy for their clients, provided that the projections do not violate the Investment Advisers Act of 1940’s antifraud rules.  Therefore, FINRA proposed the amendments to Rule 2210 in order to allow broker-dealers to use projections in a way that benefits clients and to make the rules governing performance projections by broker-dealers and investment advisers more uniform. Continue reading

The Securities and Exchange Commission (SEC) recently issued new guidance regarding the Custody Rule and inadvertent custody of client assets in the form of a No-Action Letter on standing letters of authorization (SLOAs) and a Guidance Update on custodial contract authority. This guidance comes in the wake of the recent SEC Risk Alert identifying most frequent compliance issues found in examinations of registered investment advisers and listing custody as one of these most frequent compliance issues.

The Custody Rule, or Rule 206(4)-2, provides that it is a fraudulent, deceptive, or manipulative act within the meaning of section 206(4) of the Investment Advisers Act of 1940 for a registered investment adviser to have custody of client assets unless certain requirements are met. One of these requirements is an annual surprise examination requirement, although this requirement does not apply if the investment adviser solely has custody as a result of its authority to make advisory fee deductions. Continue reading

On February 7, 2017, the Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) released a list of five compliance topics that are the most commonly identified topics “in deficiency letters that were sent to SEC-registered investment advisers.”  OCIE published this list in a National Exam Program Risk Alert in order to help advisers who are conducting their annual compliance reviews.

The first compliance topic was compliance with the Compliance Rule, Rule 206(4)-7, which requires an investment adviser to create and execute written policies and procedures that are reasonably tailored to prevent the investment adviser and its supervised persons from violating the Advisers Act and to detect potential violations.  The rule also requires an investment adviser to review the sufficiency of its policies and procedures at least annually and to appoint a chief compliance officer.  According to OCIE, common violations of the Compliance Rule include not having a compliance manual that is reasonably suited to the adviser’s method of doing business, failure to conduct annual reviews or annual reviews that did not cover the sufficiency of the investment adviser’s policies and procedures, failure to follow policies and procedures, and compliance manuals that are outdated.

The second topic that OCIE identified was compliance with the Advisers’ Acts rules on regulatory filings.  For example, Rule 204-1 provides that investment advisers must make amendments to their Form ADV on at least an annual basis, and the amendments must be made “within 90 days of the end of their fiscal year and more frequently, if required by the instructions to Form ADV.”  For investment advisers to private funds, Rule 204(b)-1 provides that an investment adviser must file a Form PF if the investment adviser is advising a private fund or fund with assets of $150 million or more.  Finally, Rule 503 of Regulation D of the Securities Act of 1933 provides that issuers of private funds must file a Form D, and investment advisers usually file the Form D for their private fund clients.  OCIE determined that the most frequent violations of these rules were inaccurate disclosures on Form ADV Part 1 or Part 2A, late modifications to Form ADVs, faulty and late Form PF filings, and faulty and late Form D filings.

On December 13, 2016, the Arizona Court of Appeals (“Court of Appeals”) affirmed an Arizona Superior Court’s decision finding that Patrick Shudak, an investment adviser, violated the Arizona Securities Act by acting as an unregistered securities salesperson or dealer in connection with the sale of interests in a real estate venture.

From January 2008 through July 2009, Shudak sold membership units in a company known as Parker Skylar & Associates, LLC (PSA).  Neither Shudak nor PSA was registered as a securities salesperson or dealer under the Arizona Securities Act.  Shudak stated in PSA’s promotional materials that the money invested in PSA would “be used to purchase and develop real property.”  In reality, however, Shudak placed the money that investors put into PSA into his personal account, the personal accounts of others such as his girlfriend, and business accounts of other business that Shudak owned or had some affiliation with.

In December 2009, investors started to grow worried when Shudak stopped returning phone calls and replying to the investors’ demands for information.  As a result, Shudak was obligated to stop serving as PSA manager and to give up his PSA membership.  He subsequently filed for bankruptcy in April 2010.

On January 25, 2017, the Securities and Exchange Commission (“SEC”) filed a complaint in the District Court for the District of Massachusetts (“District Court”) against Strategic Capital Management, LLC (“SCM”), an investment advisory firm, and its owner, Michael J. Breton.  The complaint alleges that Breton, through SCM, garnered about $1.3 million by defrauding clients using what is known as a “cherry-picking” scheme.  The action follows a similar action brought by the SEC last October.

According to the SEC, cherry-picking occurs when an investment adviser “defrauds clients by purchasing stock and then waiting to see if the stock price goes up, or down, before deciding whether to keep the trades… or to put the trades into clients’ accounts.”  Cherry-picking typically involves the investment adviser allocating more profitable trades to its own accounts and allocating less profitable ones to client accounts.  It is a breach of fiduciary duty because it entails an investment adviser placing its interests above those of its clients.

The SEC’s complaint alleges that from about January 2010 through August 2016, Breton and SCM were investment advisers to numerous client accounts.  Breton, through SCM, bought public companies’ securities using a block trading omnibus account known as a “Master Account.”  Through this Master Account, Breton was permitted to make orders for both his personal accounts and his clients’ accounts.

On January 17, 2017, the Securities and Exchange Commission (“SEC”) issued ten Orders Instituting Administrative and Cease-and-Desist Proceedings (“Orders”) against ten investment advisory firms.  In each of its Orders, the SEC alleges that each investment advisory firm gave money to campaigns for politicians who, if elected, would have the power to determine the choice of investment advisers to oversee government assets, and subsequently gave investment advisory services to public pension funds.  According to the SEC, these actions constituted violations of the Investment Advisers Act of 1940 (“Advisers Act”).

Rule 206(4)-5(a)(1), commonly known as the Pay-to-Play Rule, provides that investment advisers who are registered with the SEC, foreign private advisers, and exempt reporting advisers are not permitted to provide “investment advisory services for compensation to a government entity within two years after a contribution to an official of a government entity made by the investment adviser or any covered associate of the investment adviser.”  This rule applies regardless of whether the investment adviser or covered person intended to sway the official.  According to the SEC’s Orders, five of the investment advisory firms were SEC-registered investment advisers, while the remaining five were exempt reporting advisers.  Thus, all ten of the investment advisory firms were subject to the provisions of Rule 206(4)-5(a)(1). Continue reading

The Department of Labor (DOL) recently issued two new sets of FAQ guidance regarding the revised definition of fiduciary investment advice under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code of 1986 (Code), as well as the new prohibited transaction exemptions (PTEs). The first set of guidance is directed to retirement investors, not advisers, and answers basic questions investors may have regarding the new rule and how it will work. The second set of guidance is aimed at financial service providers and focuses mainly on the revised definition of fiduciary investment advice and the situations in which fiduciary duties will or will not attach under the new rule.

While the first set of FAQ guidance is not necessarily aimed at financial service providers, it did provide a few useful insights that I will briefly discuss here. The DOL stated that the new rule does not require advisers to indiscriminately move clients from commission-based accounts to fee-based accounts, and instead requires advisers to act in the client’s best interest when deciding what type of account to recommend. Regarding the best interest requirement, the DOL clarified that providing investment advice in a client’s best interest does not mean that advisers have a duty to find the best possible investment product for clients out of all the investments available in the marketplace. Continue reading

On January 12, 2017, the Office of Compliance Inspections and Examinations (“OCIE”) of the Securities and Exchange Commission (“SEC”) published its examination priorities for 2017.  OCIE selects its priorities based on practices and products that it believes to constitute significant risks to investors and the investment markets.  It also receives insight from a variety of sources, such as staff from the SEC’s regional offices and other regulators.  The priorities for 2017 are primarily based around protection of retail investors, protection of elderly and retiring investors, and addressing market-wide risks like cybersecurity and anti-money laundering.

The first priority that OCIE plans to emphasize is the protection of retail investors.  Over the years, new technology has provided investors with new, innovative ways to invest their finances.  As a result, the SEC and other regulators must regulate new potential risks that are bound to occur.  To address the possible challenges that retail investors face, OCIE plans to implement a number of examination initiatives.  For example, it plans to evaluate registered investment advisers and broker-dealers who provide electronic investment advice, such as “robo-advisers.”  It also intends to pay particular attention to wrap fee programs and exchange-traded funds (“ETFs”), as well as enlarge its Never-Before-Examined Adviser Initiative program.  Finally, OCIE intends to address the challenges related to investment advisers who operate on a multi-branch business model Continue reading