Introduction

Registered investment advisers (RIAs) are required to review their policies and procedures on at least an annual basis. Below is a guide to recent enforcement actions and other material developments in 2015 and 2016. While some of the regulatory focus areas are likely to change in President-elect Trump's administration, it is difficult to discern what those changes would be.1

Developments

In 2016, the Securities and Exchange Commission (SEC) adopted an order to increase the qualified client threshold effective August 15, 2016, and adopted amendments to Form ADV and its recordkeeping rules with a compliance date of October 2017. Beyond these rule changes, the Securities and Exchange Commission (SEC) proposed a new rule for business continuity plans that could establish current best practices on this topic. The SEC continues to actively pursue enforcement actions against investment advisers to private funds. Other regulatory agencies, such as the Federal Trade Commission (FTC) and the Department of Justice (DOJ), have also increased their focus on private funds and their advisers.

In reviewing their compliance manuals and disclosures for developments in 2016-17, investment advisers should consider adopting or revising policies relating to the following:

  • Codes of Ethics Requirements. The SEC has recently begun bringing actions under the code of ethics rule even in the absence of insider trading violations of the investment adviser. For example, it pursued actions against investment advisers under the code of ethics requirement for:

    • failing to subject a consultant who provided the investment adviser with investment recommendations to the adviser's code of ethics2
    • permitting the ordinary employees of a political intelligence investment adviser firm that regularly received confidential information to themselves assess whether the information passed onto clients was material nonpublic information (MNPI) instead of providing information to its chief compliance officer (CCO) to assess whether it possessed MNPI3
    • excessively crossing "walls" that made informational barriers ineffective.4
    Investment advisers should also review developments in insider trading and market manipulation enforcement when assessing their code of ethics controls. First, as evidenced by its action in 2016 against a manager who received information from a government employee, the SEC is continuing to focus on cases involving government employees in sensitive positions. Investment advisers should review their policies to ensure that they address the potential receipt of information from government sources.5 Second, the SEC brought and settled an action against a trader at an investment bank who made material representations regarding the market for the securities he was purchasing or selling.6 While many of the concerns relate specifically to broker-dealers, investment advisers may wish to address potential misstatements in their codes of ethics.
  • Broker-Dealer Activity. The SEC expanded its enforcement focus on unregistered broker-dealer activity in 2016 by targeting transaction-based compensation and persons who recommend securities and receive compensation from issuers without disclosing it.7

    The SEC brought and settled an enforcement action against a private fund manager for what it viewed as brokerage services on behalf of its portfolio companies.8 In particular, the SEC emphasized that the investment adviser performed the following services for its portfolio company and was compensated with transaction-based compensation:9

    • solicitation of deals
    • identification of buyers or sellers
    • arrangement of financing
    • execution of transactions.
    Private equity fund managers should review the services they provide to their fund portfolio companies, along with the types of compensation received to avoid broker-dealer issues. For additional information regarding this enforcement action, see our alert available at https://www.akingump.com/en/news-insights/sec-targets-broker-dealer-implications-of-transaction-based-deal.html.

    The SEC approved a new category of broker-dealer registration with the Financial Industry Regulatory Authority, Inc. (FINRA) for "capital acquisition brokers," which will be subject to a lighter level of regulation and oversight. Capital acquisition brokers are engaged in:

    • advising an issuer, such as a private fund, concerning its securities offerings or other capital-raising activities, including through acting as a finder or placement agent
    • advising a company regarding the purchase or sale of a business or assets
    • assisting in the preparation of offering materials
    • providing fairness opinions and valuation services
    • acting as a placement agent or finder
    • effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company.
    The addition of this new broker-dealer regime may cause the SEC to focus on the activities of internal marketing personnel of private fund managers. For further information regarding the regulation of capital acquisition broker-dealers, see the SEC order approving the new FINRA rules available at https://www.sec.gov/rules/sro/finra/2016/34-78617.pdf.
  • ADV Amendments and Recordkeeping Rule. On August 25, 2016, the SEC amended (i) Form ADV to collect additional information regarding separately managed accounts and to accommodate umbrella registration,10 and (ii) its recordkeeping rule to require all communications with performance claims to be retained. While the compliance date is delayed until October 1, 2017, investment advisers may consider revising their record retention policies earlier. In addition, investment advisers may wish to review the comparison versions of the Form ADV Part 1A available at https://www.sec.gov/rules/final/2016/ia-4509-form-adv-summary-of-changes.pdf and the Form ADV General Instructions, Instructions to Part 1A and Glossary available at http://apps.akingump.com/compliancecalendar2016. Investment advisers may wish to address any practices that may prompt undesirable disclosure once the compliance date occurs.
  • Qualified Client Revision. Effective on August 15, 2016, the SEC adjusted the net worth threshold for a registered investment adviser to charge performance-based compensation to its advisory clients or investors in 3(c)(1) private funds from $2 million to $2.1 million (not including the client's or investor's primary residence and related debt).11 For further detail and information regarding grandfathering, see our previous alert available at https://www.akingump.com/en/news-insights/sec-orders-increase-in-qualified-client-threshold.html.
  • Distribution of Unverified Performance. The SEC brought and settled actions against 13 investment advisers that repeated the false performance claims of another investment adviser without verification.12 The SEC's actions claimed that the investment advisers had violated the advertising rule through negligently distributing advertisements that contained misrepresentations and the books and records rule by not keeping records to form the basis for, or demonstrate the calculation of, the performance or rate of return that it circulated. These actions show that the SEC will now aggressively pursue an investment adviser for performance information that it circulates, but did not create. Investment advisers should consider whether they have adequate backup for statements of third parties before including them in advertisements.
  • Business Continuity Plans. The SEC proposed a new Rule 206(4)-4 under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), in June 2016 that would require registered investment advisers to establish business continuity plans and transition plans satisfying certain criteria. Pursuant to SEC guidance in connection with the investment adviser compliance rule, registered investment advisers are already required to adopt business continuity plans. Therefore, the SEC could use the proposed business continuity plans rule to interpret what the required elements are for business continuity plans. For a checklist of elements of the proposed business continuity plans, as well as the transition plan requirements described in the release (which may be substantially changed before final adoption), see http://apps.akingump.com/compliancecalendar2016.
  • Supervisory Controls Relating to Supervised Persons with Disciplinary History. On September 12, 2016, the SEC's Office of Compliance Inspections and Examinations announced13 that it is undertaking an initiative to examine the practices and programs of registered investment advisers that employ individuals with a history of disciplinary events ("Disciplined Individuals").14 In particular, the examinations will focus on the relevant investment adviser's:

    • policies and procedures for hiring, ongoing reporting obligations, complaints and oversight of Disciplined Individuals
    • disclosures in their Form ADV regarding Disciplined Individuals and whether the disclosures are accurate, adequate and effective
    • conflicts of interest involving Disciplined Individuals, especially with respect to special financial arrangements
    • marketing or advertising related to Disciplined Individuals.
    Investment advisers employing Disciplined Individuals should review their supervisory practices with respect to those employees. In addition, investment advisers should consider whether they have implemented adequate screening procedures in their hiring processes.
  • Allocations of Expenses and Fees. The SEC continues to target allocations of expenses between clients and the investment adviser at both the fund and portfolio-company level. For example, the SEC brought and settled enforcement actions against investment advisers for, among other things, (i) expensing a portion of a luxury suite at an arena without retaining adequate records to demonstrate the division between personal and business uses, (ii) making political and charitable contributions with fund assets, (iii) expensing liability insurance to fund clients, when some risks covered by the insurance did not relate to the fund clients,15 (iv) expensing the salary of one of the investment adviser's employees to a portfolio company while he was serving as a temporary employee of the portfolio company,16 and (v) causing its fund clients to sponsor a separate investment adviser and to pay the newly formed adviser's expenses.17 The SEC has also targeted the method of allocation of fee income and related management fee offsets.18 Finally, the SEC targeted an investment adviser that received preferential terms from its service providers as compared to its clients.19 The SEC treats expense allocation and fee calculation issues as a policy failure,20 and, therefore, we recommend that investment advisers have expense allocation policies that address how expenses and fees are allocated and that those policies are disclosed to investors.
  • Allocation of Investments to Appropriate Clients. The SEC brought and settled an enforcement action21 against an investment adviser that overallocated initial public offerings to a fund client that specialized in illiquid and distressed investments instead of its larger multistrategy fund. While the SEC's concern may be attributable to the larger size of the investment adviser's principal's ownership in the illiquid fund, this action demonstrates that the SEC will scrutinize the relative allocation of investments in light of the client's strategy.
  • Investor Relationships. The SEC has also brought enforcement actions relating to the failure to disclose the disparate treatment of limited partners in 2016. For example, it has targeted investment advisers that waived capital calls for affiliated investors22 and permitted redemptions by related-party investors while retaining restrictions on third-party investors.23 Investors may increasingly complain to the SEC in addition to seeking redress through state courts.

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Footnotes

1. See our 2016 postelection report "Preparing for a Trump Presidency" available at https://www.akingump.com/images/content/5/3/v2/53023/Postelection-Report-2016-Trump-Presidency.pdf for a description of potential priorities of President-elect Trump's administration.

2. See Release IA-4401 (May 27, 2016) available at https://www.sec.gov/litigation/admin/2016/ia-4401.pdf.

3. See Release IA-4279 (Nov. 24, 2015) available at https://www.sec.gov/litigation/admin/2015/34-76512.pdf.

4. See Release IA-4221 (Oct. 8, 2015) available at http://www.sec.gov/litigation/admin/2015/34-76109.pdf.

5. See Press Release 2016-119 (Jun. 15, 2016) available at https://www.sec.gov/news/pressrelease/2016-119.html. 

6. See Release IA-4487 (Aug. 16, 2016) available at https://www.sec.gov/litigation/admin/2016/34-78585.pdf.

7. See Press Release 2016-65 (Apr. 11, 2016) available at https://www.sec.gov/news/pressrelease/2016-65.html. The United States District Court for the Eastern District of Texas conditionally granted a motion to dismiss, but the SEC has filed an amended complaint that has not yet been adjudicated.

8. See Release 34-77959 (Jun. 1, 2016) available at https://www.sec.gov/litigation/admin/2016/34-77959.pdf.

9. The enforcement action did not expressly address whether the compensation was subject to offset against the management fee paid by the fund client, but it did state that the adviser had received approximately $1.9 million in transaction-based compensation in connection with providing the brokerage services and that the transaction and brokerage fees were expressly permitted in the fund documents. A senior member of the SEC staff has previously stated, "to the extent the advisory fee is wholly reduced or offset by the amount of the transaction fee, one might view the [transaction] fee as another way to pay the advisory fee, which, in my view, in itself would not appear to raise broker-dealer registration concerns." See David W. Blass, Chief Counsel, Division of Trading and Markets, "A Few Observations in the Private Fund Space," Address at the Trading and Markets Subcommittee Meeting of the American Bar Association (Apr. 5, 2013) available at http://www.sec.gov/news/speech/2013/spch040513dwg.htm. 

10. The SEC did not expand the scope of the "relying adviser" registration beyond previous staff guidance in the revised Form ADV. First, the SEC declined to permit registered investment advisers with a principal office and place of business outside the United States of America to act as the "filing adviser" for the umbrella registration. Second, the SEC did not permit exempt reporting advisers to use the new "relying adviser" schedules to file an aggregated report with their affiliates.

11. Rule 205-3 excludes the value of the primary residence as an asset and debt secured by the primary residence as a liability, except to the extent (1) that the value of the debt would exceed the value of the residence and (2) of any increase in debt secured by the person's primary residence occurring within 60 days prior to entering into the advisory contract or investing in the 3(c)(1) private fund on the liability side of the net-worth calculation, unless the increase was a result of the acquisition of the primary residence.

12. See Press release 2016-167 (Aug. 25, 2016) available at http://www.sec.gov/news/pressrelease/2016-167.html.

13. National Exam Program Risk Alert, Volume V, Issue 3 (Sept. 12, 2016) available at https://www.sec.gov/ocie/announcement/ocie-2016-risk-alert-supervision-registered-investment-advisers.pdf.

14. The SEC will draw upon its own databases, as well as "external sources."

15. See Release IA-4529 (Sept. 14, 2016) available at https://www.sec.gov/litigation/admin/2016/ia-4529.pdf.

16. For further information regarding this enforcement action, see https://www.akingump.com/en/news-insights/sec-targets-broker-dealer-implications-of-transaction-based-deal.html.

17. See Release IA-4529 (Sept. 14, 2016) available at https://www.sec.gov/litigation/admin/2016/ia-4529.pdf.

18. For further information regarding this enforcement action, see https://www.akingump.com/en/news-insights/sec-targets-broker-dealer-implications-of-transaction-based-deal.html.

19. See Release 34-77959 (Jun. 1, 2016) available at https://www.sec.gov/litigation/admin/2016/34-77959.pdf.

20. See Release IA-4441 (Jun. 28, 2016) available at https://www.sec.gov/litigation/admin/2016/34-78189.pdf.

21. See Release IA-4413 (Jun. 2, 2016) available at https://www.sec.gov/litigation/admin/2016/ia-4413.pdf.

22. For further information regarding this enforcement action, see https://www.akingump.com/en/news-insights/sec-targets-broker-dealer-implications-of-transaction-based-deal.html

23. See Lit. Release 23597 (Jul. 18, 2016) available at https://www.sec.gov/litigation/litreleases/2016/lr23597.htm. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.