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The Securities and Exchange Commission (SEC) is taking an increased interest in examining chief compliance officers (CCO) to determine whether enforcement action should be taken against them. At the Investment Adviser Association’s annual compliance conference, CCOs were given a number of stern warnings. Director of the SEC’s Division of Investment Management Robert Plaze spoke about changes and improvements being made by the SEC. He warned CCOs that a newly created Asset Management Unit, which is part of the Division of Enforcement, “is dedicated to suing you.” He also claimed that the new unit will be staffed with people who understand the asset management business. It will also collaborate with both the Investment Management Division and the agency’s Office of Compliance Inspections and Examinations. Mr. Plaze stated that the unit will make the SEC’s oversight of registered investment advisers more efficient, allowing it to be able to perform more effective examinations. These warnings should concern CCOs who have taken a supervisory role within their firm.

The SEC has the authority to impose sanctions on people who are associated with a broker-dealer or an investment adviser if those people have reasonably failed to supervise. Both broker-dealers and investment advisers employ legal and compliance personnel to provide advice to them and their firms regarding the application of laws and regulations. One major issue that arises is whether the CCO is considered a supervisor within the firm. If so, the CCO could be subject to sanctions by the SEC for failure to supervise.
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As a result of the financial crisis, the Financial Industry Regulatory Authority (FINRA) has significantly increased number of enforcement actions and the amount of sanctions imposed on broker-dealers in the previous year. According to Sutherland Asbill & Brennan LLP’s annual sanctions survey, the 13% increase in disciplinary actions resulted in increased fines of 51%.

FINRA filed 1,488 disciplinary actions in 2011, an increase from the 1,310 actions that it initiated in 2010. This made 2011 the third straight year in which the number of FINRA disciplinary actions has grown. The survey also found that the number of professionals barred by FINRA increased from 288 in 2010 to 329 in 2011.

Total fines jumped from $45 million in 2010 to $68 million in 2011, which is a 51% increase. The survey report stated, “While the $68 million reported in 2011 is still a far cry from the $184 million and $111 million that FINRA fined firms and representatives in 2005 and 2006, respectively, it may signal continued enforcement efforts for the near future.”
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The Commodities Future Trading Commission (CFTC) has adopted a final rule that makes several amendments to Regulation 4.5, which relates to commodity pool operators. The amendments add new limitations to an exclusion from the definition of a commodity pool operator (CPO) upon which registered investment companies have commonly relied. Currently, the rule excludes from the CPO definition entities that operate under other regulatory regimes, such as registered investment companies, banks, certain pension funds and insurance companies.

The amended regulations now impose two restrictions on registered investment companies that seek to use this exclusion. The first restriction is a trading threshold which would require an adviser to a registered investment company to either certify in a notice of eligibility filed with the NFT that it uses commodity futures, options or swaps only for “bona fide hedging purposes,” or, alternatively, that it meets one of the following two tests:

  • Five percent test: In relation to positions in commodity futures, commodity option contracts or swaps, the aggregate initial margin and premiums required to establish those positions will not exceed five percent of the liquidation value of its portfolio, after taking into account unrealized profits and unrealized losses; or
  • Net notional value test: the aggregate net notional value of commodity futures, commodity option contracts or swap position not solely used for “bona fide hedging purposes,” determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the registered investment company’s portfolio, after taking into account unrealized profits and unrealized losses. The net notional value is calculated as described in CFTC Regulation 4.13(a)(ii)(B)(1) and 4.13(a)(ii)(B)(2).

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With an overwhelming majority, 390 to 23, the House of Representatives passed another crowdfunding bill on March 9, 2012. The House had previously passed a similar bill in November 2011 called the “Entrepreneur Access to Capital Act” which we previously discussed in a blog, New “Invest Georgia Exemption” Helps Small Businesses Raise Capital. That Republican bill stalled in the Democratic-controlled Senate, as did another bill related to crowdfunding requirements which included lower investment amounts and the requirement to use a “crowdfunding intermediary.” The Senate currently has three crowdfunding bills before it, although none of the bills have yet to move out of committee. The Senate Banking Committee did hold another hearing on the topic of crowdfunding earlier this week.

The bill that passed most recently in the House was originally introduced by Representative Patrick McHenry (R-NC) and was rolled into a broader package called the Jumpstart Our Business Startups (JOBS), which included six bills bundled together. Rep. McHenry stated, “Crowdfunding is a key component of the JOBS Act. Economists predict the legislation will lead to a ten percent increase in new business startups, helping to create at least 170,000 jobs in the next five years. The bill is critical in getting our economy back on the right track.”
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The Securities and Exchange Commission (SEC) issued a Risk Alert on February 27 designed to help firms detect and prevent unauthorized trading in brokerage and advisory accounts. Carlo di Florio, director of the Office of Compliance Inspections and Examination, stated, “Unauthorized trading is not a new problem, and the risks it poses should be a perennial concern to financial firms as well as to regulators. We hope that the observations shared in the Risk Alert will be helpful for firms as they review their compliance and supervisory controls to detect and deter unauthorized trading.”

The Risk Alert defines the term “unauthorized trading” as a broad range of activities, including: (1) rogue or other unauthorized trading or trade execution in customer or client or propriety accounts, (2) exceeding firm limits on position exposures, risk tolerances and losses, (3) intentional mismarking of positions, and (4) creating records of nonexistent (or sham) transactions. If a firm notices a change in trading patterns, a high volume of trade cancellations or corrections, manual trade adjustments, or unexplained profits for a particular trader or client, then the firm may need to apply additional scrutiny.
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The Securities and Exchange Commission (SEC) and the Commodities Future Trading Commission (CFTC) issued a joint proposed rule and guidelines to help protect investors from identity theft enacted by Title X of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This proposal currently does not apply to registered investment advisers. The SEC has recognized that registered investment advisers are unlikely to hold transaction accounts and thus would not qualify as a “financial institution.” The SEC is requesting comments on the proposed rule asking whether the rule should “omit investment advisers or any other SEC-registered entity from the list of entities covered by the proposed rule?” When the proposal is published in the federal register there will be a 60-day comment period.

Section 1088 of the Dodd-Frank Act transferred authority over parts of the Fair Credit Reporting Act (FCRA) from the Federal Trade Commission (FTC) to the SEC and the CFTC. The provisions amended section 615(e) by adding the CFTC and SEC to a list of federal agencies required to create identity theft regulations. The purpose of an identity prevention program is to detect, prevent and mitigate identity theft.
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Virginia’s previous private fund adviser exemption could be short-lived because it may be replaced by a new proposed rule. The previous rule was effective September 7, 2011 and the current proposed rule is expected to be effective on May 1, 2012. Interested persons may submit their comments on the proposed rule on or before April 12, 2012. This new rule is also currently being considered by California, Massachusetts and Rhode Island. We previously discussed the California proposed exemption rule in a blog, California Extends Comment Date on its Proposed Private Fund Exemption Rule.

Currently, the rule provides for an exemption for any adviser where the adviser advises only clients that are either a corporation, general partnership, limited partnership, limited liability company, trust or other organization that:

  • Has assets of $5,000,000 or more and
  • Receives investment advice based on the investment objectives of the entity instead of individual investment objectives, provided that the adviser was exempt from registration pursuant to §203(b)(3) of the Investment Advisers Act of 1940 and the adviser is subject to SEC rule 203 1(e).

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The Securities and Exchange Commission (SEC) is looking into two new proposals to stabilize money market funds. One of Chairman Mary Schapiro’s goals is to address the core structural weaknesses of the market. She stated, “Funds remain vulnerable to the reality that a single money market fund breaking of the buck could trigger a broad and destabilizing run.” The SEC is hoping to put both plans out for public comment, but it believes that it may adopt only one of the plans. If it chooses to adopt one, then the SEC will propose it before the end of March.

The SEC’s first proposal is to adopt a floating net asset value instead of the traditional $1 share price. This idea was also mentioned back in 2009; however it was not implemented. The second proposal would require funds to maintain a 1% capital cushion designed to absorb potential losses and to hold back at least 3% of client redemptions for 30 days.
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The Obama administration released a proposed budget last week that will boost the Securities and Exchange Commission’s (SEC) budget for the next fiscal year. The SEC claims the need for an increased budget stems from the mandatory creation of 100 rules which is required by the Dodd-Frank Act and the need to hire new examiners to regulate the market more efficiently. The proposed budget would increase the SEC’s funding by 18.5 percent from $1.32 billion to $1.57 billion.

Prior to the release of the Obama administration budget, the SEC submitted a budget request which stated that the new budget would allow for 222 new examiners. That request estimated that in 2013 it will be responsible for examining 10,000 advisers with $44 trillion in assets under management. Currently, it only has 10 examiners per $1 trillion in assets under management, a decrease since 2005 when it had 19 examiners for every $1 trillion in assets under management. The SEC is capable of reviewing only eight percent of registered advisers each year. Investment advisers have also shown a preference to be regulated by the SEC as opposed to FINRA or another self regulatory authority (SRO), as we discussed in a previous blog, BCG Report Claims FINRA Cost Will Exceed SEC Cost as RIA SRO.
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The Securities and Exchange Commission (SEC) released Final Rule No. IA – 3372 which changes the qualifications for advisers who charge performance fees. We discussed the proposed amendment to the rule in a previous blog post, Performance Based Fee Threshold Increase Sought by SEC in Proposed Order. These amendments are required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, and will take effect 90 days after publication in the Federal Register, which is anticipated shortly. Until then advisers can rely on the grandfather provisions.

While advisers are generally unable to accept performance fees, there are exceptions. For example under certain circumstances, a client may become a “qualified client,” under Rule 205-3, meaning he or she is deemed to be capable of bearing the risks associated with performance fee arrangements. Under the new rule, an adviser may charge performance fees to “qualified clients” who have at least $1 million of assets under management for that definition to apply. Under the previous rule, $750,000 in assets were required to be under management. Also, the net worth of an investor may also be a qualification for an exception. The amended rule raises the minimum net worth standard for qualified clients from $1 million to $2 million. (The other “qualified client” basis includes clients who immediately before entering the advisory contract are either executive officers, directors, trustees, general partners of the adviser or employees of the adviser and who have participated in the adviser’s investment activities for at least twelve months. This definition has not changed with the amendment.)
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