Last week the Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) released updated guidance to the disciplinary disclosures section of Form CRS. The purpose of Form CRS is to provide a succinct summary of the business of the Investment Adviser or Broker-Dealer to provide a retail investor with the proper information to make an informed decision regarding whether an investment advisory or brokerage relationship is in the best interest of the investor. Form CRS also provides a platform to generate questions for clients to ask their financial professional to spark a conversation regarding the disclosures. Likewise, the purpose of the disciplinary section of the Form CRS is to give an overall indication as to whether the firm or its financial professionals have disciplinary history to disclose.

The SEC and FINRA place a high level of importance on ensuring that firms adequately disclose their disciplinary history to provide full and accurate disclosure to retail investors. Since June 30, 2020, the required implementation date of Form CRS, the SEC and FINRA have examined investment advisers to determine compliance with the guidance regarding Form CRS and Regulation BI. In its examinations, the regulators determined that many investment advisory and brokerage firms were either not providing a response to the disciplinary section or providing more details than the section’s instructions require. The following are summaries of the updated guidance on Form CRS disciplinary disclosures:

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The Office of Compliance Inspections and Examinations (“OCIE”) published a Risk Alert highlighting the need for investment advisers to prevent unauthorized access to client data stored on websites.

Recently, cyber attackers have used “credential stuffing” and other methods to breach web-based user accounts. Credential stuffing is when a hacker combines lists of stolen account information from the dark web and customized scripts to compromise user names and passwords to other sites. Hackers prefer this method because it seems to be more efficient and successful than more traditional methods of hacking, like a brute force attack.

OCIE has the following recommendations for Investment Advisers to consider in protecting themselves and their websites against credential stuffing attacks: Continue reading ›

In July 2020, the Securities and Exchange Commission issued supplemental guidance relating to the duties of investment advisers with respect to proxy voting. This follows guidance issued in 2019, which we have discussed before. The prior guidance was issued in connection with amended rules finalized at the same time which dealt with proxy solicitations under the federal securities laws. Those amendments were designed to grant companies that issue stock to obtain advisory firms’ recommendations on proxy issues in advance of the proxy submission deadline. As a result, the issuer has time to submit additional materials as part of the proxy solicitation.

As a result of the new rules, proxy voting services will be forced to share their voting recommendations with the issuers of the securities at or prior to the providing the recommendations to their institutional clients, and if issuers submit additional information in response, must also disclose such information to the clients. The proxy advisers must also disclose any conflicts of interest that might exist that could reasonably be expected to influence their recommendations.

The effective date of the amended rule is 60 days after publication. Proxy advisory firms must comply with the amendments by December 1, 2021. The supplemental guidance became effective on September 3, 2020. Continue reading ›

As illustrated in two recent cases, the SEC’s Enforcement Division continues to root out RIAs that receive excessive undisclosed fees, particularly 12b-1 fees and mutual fund revenue sharing payments. As we have noted repeatedly, the SEC has focused on this issue in the last several years. At issue is whether an adviser properly disclosed to its clients that its representatives or an affiliated broker-dealer would receive 12b-1 fees based upon the recommendation of a mutual fund share class that pays such a fee when other classes that do not carry such a fee are available to the client.

In the first case, SCF Investment Advisors (SCF), a California-based registered investment adviser, consented to more than $700,000 in monetary sanctions imposed by the SEC relating to the firm’s practice of receiving 12b-1 fees in advisory accounts without proper disclosure. According to the order, SCF used mutual funds and money market funds that paid 12b-1 fees, although the receipt of those fees was not disclosed to clients and less expensive alternatives were available. The firm’s affiliated broker-dealer also received revenue sharing payments, a practice that was also not disclosed. As a result of those charges, SCF and its affiliates were unjustly enriched, and the clients’ performance was lower than it would have been had the practices not existed.

In 2018, the SEC granted RIAs the opportunity to enter into consent orders that did not carry civil penalties by self-reporting the receipt of undisclosed 12b-1 fees. In those cases, however, the firms would nevertheless be required to reimburse clients the amounts received in 12b-1 fees. In April of this year, as a result of that self-disclosure initiative, the SEC announced that the initiative resulted in 95 RIAs returning nearly $140 million to their customers. Continue reading ›

In a closely-watched move, the SEC voted 3-2 this past Wednesday to expand the definition of an “accredited investor” to include both state-registered and SEC-registered investment advisers with $5 million or more in assets. Accredited investors are those who are permitted to purchase unregistered securities such as those typically sold in a private placement. The current definition includes individuals or married couples with $1 million or more in investments and individuals with $200,000 in annual income or total income with a spouse of $300,000.

Also added to the definition are individuals who hold Series 7, 65, and 82 licenses. Those correspond to examinations for the general securities agent or representative, the investment adviser representative, and the private placement agent, respectively. “Knowledgeable employees” of a private fund are now also accredited investors. In addition to the new categories included, the Commission established a framework whereby additional categories of sophisticated investors can be added to the definition over time.

The Commission also voted not to adjust upward for inflation, the traditional wealth-based definition of “accredited investor.” The issue exposes a fundamental debate about the adequacies of protections that currently exist in the private securities market, as well as issues of class-based access to markets.

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Earlier this summer, the US Supreme Court handed down a highly anticipated decision clarifying the powers of the Securities and Exchanges Commission in civil enforcement proceedings. The court ruled by a margin of 8 to 1 that the SEC can obtain disgorgement from a defendant because disgorgement is a form of equitable relief. As such, the remedy is based on district courts’ inherent powers to enter remedies based on fairness and equity. But we anticipate that the lower courts will still have difficulty in answering questions relating to the equitable remedy with uniformity, most likely resulting in those questions eventually coming back to the high court for resolution.

The case, Liu v. SEC, involved a lower court’s order that a married couple must pay $27 million in disgorgement as a result of the husband’s raising that amount from Chinese investors in a fraudulent EB-5 offering. The funds were ostensibly raised to fund a new cancer clinic, but ultimately the funds were misused. The husband funneled some of the money to the wife and some to other related companies. Both husband and wife were paid millions of dollars in salaries alone. The disgorgement award held both husband and wife jointly and severally liable for the full amount.

The trial court ordered the couple to disgorge the full amount raised in the fraudulent scheme as “ill-gotten gains.” The defendants challenged the amount of disgorgement imposed on several grounds, including that the amount should be offset by legitimate expenses incurred by the defendants. A disgorgement award that was not limited to net profits, they argued, constituted a penalty and therefore, could not be imposed consistent with other limitations on awards of civil penalties. Continue reading ›

The Securities and Exchange Commission (“SEC”) recently published its sixth risk alert on cybersecurity since 2014. In this alert, the SEC focused on how its regulated firms protect themselves against ransomware risk. I previously wrote about the SEC’s last risk alert on ransomware here.

Ransomware is malware that stops a user from accessing either part or all of the data within their network or other systems until a ransom is paid. For ransomware to be effective, it must gain access to network data in some form or fashion, usually through user error, such as a user clicking a link, downloading a file, or doing something else which affirmatively provides the ransomware access to data. From there, the hacker typically encrypts data and demands payment to unencrypt it.

There are varying studies, but up to 90% of financial services firms, including investment advisers, broker-dealers and investment companies, report that they have been targeted by ransomware. The SEC also reports that these targeted attacks have gotten more sophisticated in nature over the last few years, which necessitates greater allocation of resources from firms to protect themselves.

In late June, the U.S. Department of Labor reinstated the previous definition of “fiduciary investment advice” that was contained in its prohibited transactions rules prior to 2017. That definition was amended by the “Fiduciary Rule” that went into effect in 2017, but the new rule was ultimately struck down by the Fifth Circuit Court of Appeals. Because the DOL interprets the Fifth Circuit’s decision to have reinstated the original rule, it dispensed with the normal comment period and made the new rule effective immediately.

The original (now reinstated) definition was passed in 1975 and was applied consistently by the DOL and IRS until the 2017 Fiduciary Rule became effective, albeit temporarily.  The reinstated definition, being much narrower than the definition under the Fiduciary Rule, means that many fewer situations between plans and investment advisers will constitute “fiduciary investment advice” compared to the 2017 Fiduciary Rule and, consequently, the risk of engaging in a prohibited transaction is smaller.

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SEC Issues Risk Alert to Private Fund Advisers, Part 2

This supplements our previous post relating to a Risk Alert issued by the SEC’s Office of Compliance Inspections and Examinations on June 23. The Risk Alert was directed at investment advisers to private investment funds. While the prior post discussed the portion of the Risk Alert dealing with fees and expenses, this post discusses the SEC’s findings relating to failure to disclose conflicts of interest.

By way of background, the Risk Alert reminds private fund advisers that they owe duties of care and loyalty to the investors in private funds. In order to fulfill the duty of loyalty, the adviser may not prefer his own interests to those of the investors and must disclose to its clients, in a full and fair manner, all material facts relating to the advisory relationship. The scope of the investment adviser’s duties is discussed at length in IA-5248, issued in June 2019, which we have discussed in a previous post.

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Earlier this week, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert in which it discussed ongoing deficiencies identified during compliance examinations of investment advisers that advise private funds. This risk alert follows on the heels of other SEC activity relating to private fund advisers, including enforcement referrals, deficiency letters, and informal guidance.

The deficiencies discussed in the risk alert fall into three broad categories: disclosures relating to fees; disclosures relating to conflicts of interests; and sufficiency of a firm’s policies relating to nonpublic material information and its internal enforcement of such policies. The purpose of this risk alert was to provide guidance to private fund advisers regarding steps they should take to improve their compliance policies and program, while simultaneously advising investors in private funds of the types of issues to be aware of when dealing with private fund advisers. Many investors in private funds are pensions or other qualified retirement plans, charities and endowments, and families who have family offices.

This blog post focuses on the portion of the risk alert relating to fees and expenses. Continue reading ›

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