REGULATORY UPDATE

Securities and Exchange Commission (“SEC”) Hosts National Compliance Outreach Seminar for Investment Companies and Investment Advisers

In April 2016, the Office of Compliance Inspections and Examinations (“OCIE”), the Division of Investment Management, and the Asset Management Unit of the Division of Enforcement hosted its annual seminar for investment companies and investment advisers. Of most significance were the comments by Andrew Ceresny, the Director of the Division of Enforcement. He announced a focus on cybersecurity, conflicts of interest in the investment adviser arena, private equity fees and expenses, valuation, and governance. He stated that approximately 15–20 percent of enforcement actions are from OCIE referrals.
Mr. Ceresny noted that only a few cases have been brought against compliance officers (five in the past 13 years), and the cases were brought only when compliance officers misled regulators or wholly failed to carry out their duties and responsibilities.

SEC Comment Period Closed on Transfer Agent Modernization Concept Release

On April 14, 2016, the SEC closed its comment period on its proposed transfer agent regulations that focus on registration and reporting requirements as well as safeguarding funds and securities. Below are comments the SEC received from various industry participants relating to the transfer agent modernization concept release.

• Securities Transfer Association—establish guidance that provides additional safeguards for securities and monies controlled by transfer agents, and require transfer agents to participate in ongoing assessments of risk, including cybersecurity risks. The Staff must consider the variety of operations provided by transfer agents when drafting new rules and regulations.
• American Bankers Association—exempt bank transfer agents from rules that will conflict with or are duplicative of current federal banking rules.
• Securities Industry and Financial Markets Association—transfer agents should be held to financial industry standards of transparency and fairness in relation to clients, shareholders, and broker-dealers.
• Broadridge Financial Solutions—focus on transfer agent financial reporting, fee transparency, and technology management.
• Depository Trust & Clearing Corporation—transfer agents should be subject to increased registration, reporting, and substantive requirements to safeguard financial stability.

SEC Eases Custody Rule Exam Requisites for Sub-Advisers

In December 2009, the SEC implemented a custody rule that requires investment advisers to protect client assets. The custody rule requires investment advisers that have custody of client funds to hold the funds at a “qualified custodian,” such as a broker- dealer or a bank, and participate in annual surprise exams by an independent public accountant who provides a written internal control report that the adviser has appropriate controls over client funds. If an adviser or an affiliate of the adviser is acting as a qualified custodian, the firm must obtain a report of the internal controls related to custody of client assets from an independent registered accountant at least once a year. On April 25, 2016, the SEC issued a no-action letter to the Investment Adviser Association stating that they would not pursue enforcement actions against sub-advisers that fail to obtain annual surprise examinations from an independent public accountant, as long as the sub-adviser did not directly hold client funds. The no-action letter further states that the Staff recognized that affiliated custodial relationships present higher risks than arrangements with independent custodians, but offered relief to sub-advisers when the following four conditions are met:

• the sole basis for the sub-adviser having custody is its affiliation with the qualified custodian and the primary adviser;
• the primary adviser will comply with Rule 206(4)-2 by having a surprise exam by a PCAOB-registered independent public accountant;
• the sub-adviser does not hold client funds itself, have authority to obtain the funds, or have authority to deduct fees from client accounts; and
• the sub-adviser continues to obtain from the primary adviser or qualified custodian an annual written internal control report.

Increase Disclosure in Mutual Fund Account Statements

In April 2016, the SEC’s Investment Advisory Committee (the “Committee”) approved the recommendation to enhance disclosure of the cost of investing in mutual funds by requiring investor statements to uniformly contain disclosures of specific mutual fund costs. The Committee recommended that standardizing fee disclosures to present the actual costs of investing in a mutual fund as compared to the total fund returns, instead of as a percentage of assets under management, would provide investors with a better understanding of mutual fund costs and the significance of such costs, as well as allow investors to make more informed decisions on their investments.

On May 20, 2016, SEC Chairwoman Mary Jo White announced that the Staff will begin considering recommendations on how mutual funds can make disclosure statements more investor friendly. The Division of Investment Management has begun to assess how mutual funds can improve their disclosure relating to a fund’s strategies, holdings, risks, and fees, and how technology can be incorporated in the improvement of the presentation and delivery of such disclosure. The Staff is also focusing on how to make fee tables clearer as well as ways to increase disclosure relating to material impacts on fund performance. Chairwoman White stated, “Investment managers should continuously re-evaluate disclosures, and avoid boilerplate and tailor your disclosure as appropriate for each fund.”

SEC Will Keep Pressure on Private Equity Funds

On May 12, 2016, Andrew Ceresney stated that the SEC will continue to focus on pursuing private equity funds over undisclosed fees and expenses, impermissible shifting of fees and expenses, and fund advisers who fail to disclose conflicts of interest relating to fees. Mr. Ceresney recognized that although investors in private equity funds are usually sophisticated, many public pension plans, institutional investors, and university endowments invest in private equity funds on behalf of retail investors. Mr. Ceresney stated, “If an adviser defrauds a private equity fund, the underlying victims frequently include retail investors, who in many cases are not in a position to protect themselves,” because of the lack of transparency private equity funds have on various fees and expenses.

Independent Fund Directors Rattled By Change In Role

In December 2015, Third Avenue’s high yield fund was forced to liquidate after heavy losses in the junk bond sector and was unable to meet investor demands to withdraw their money. The collapse of this fund marked the biggest mutual fund failure since the 2008 financial crisis. In response to the failure, the SEC has begun to focus on the role of independent fund directors and their oversight responsibility to mutual funds. In March 2016, Chairwoman White stated that “independent directors will be punished if they fail to perform their duties and preside over another mutual fund failure.” The SEC would like independent directors to focus more on monitoring a fund’s liquidity risk, assess risks relating to cybersecurity, and asset managers’ use of derivatives. Many independent directors are concerned that the SEC is seeking to change their role to one of day-to-day management of a fund, which is not part of their traditional oversight role. Individuals within the industry recommend that the SEC conduct a roundtable discussion to re-evaluate the role and responsibilities of independent directors and what specific adjustments should be made based on the new regulatory environment.

SEC Comment on Current and Future Fund Regulatory Initiatives

Chairwoman White has recently increased the SEC’s focus in the investment management industry and its responsibilities to ensure investor protection. Chairwoman White stated, “investment companies must continue to foster a culture that prioritizes responsibility and fairness and ensure that products and strategies meet investors’ needs.” The Staff is currently focusing on finalizing proposed rules relating to the modernization of fund reporting, increased liquidity risk management requirements and funds’ derivative use, as well as developing recommendations for annual stress testing for specific funds and investment advisers. Additionally, the Staff has continued to focus on regulations relating to exchange traded trusts and how they can be revised based on market conditions. Chairwoman White said that the Staff has increased its focus on the liquidity of funds and noted, “the most important goal should be fulfillment of the legal responsibility to meet shareholder redemptions while minimizing the impact on remaining shareholders, and the SEC will ensure that this crucial work is done.”

SEC Official Offers Advice on Overseeing a Firm’s Compliance Function

In remarks delivered on May 20, 2016, SEC Chief of Staff, Andrew Donohue, focused on corporate compliance and the role of the Chief Compliance Officer (“CCO”). Mr. Donohue discussed five key areas that CCOs must focus on to successfully effectuate their job duties.

• Knowledge of the business-the CCO should have extensive knowledge and understanding of the business and the rules and regulations to which the organization is subject.
• Risks–the CCO must be able to identify the key risks that the organization faces on a daily basis.
• People–the CCO must understand and appreciate the organization’s people and their focus.
• Systems–the CCO must be familiar and comfortable with the systems employed at the organization, their limitations and the people involved.
• Resolution–the CCO must be able to easily identify issues and resolve issues in a timely manner.

Liquidation Piling Up This Year, Led By Alternative Funds

In 2016, alternative funds have been liquidating at a rapid pace as compared to previous years due to a combination of poor performance, the inability to attract assets, and pending regulatory proposals related to liquidity and leverage. For the alternative funds liquidated in 2016 to date, the median life of the funds was approximately two and half years. Due to the increase in the liquidation of alternative funds, if presented with the approval of an alternative fund, boards of trustees should focus on the manager’s commitment to the fund, the manager’s experience with advising an alternative fund, and, if sponsored or sub-advised by a hedge fund, what that adviser’s experience and success is with a similar strategy. Boards should also focus on the extent to which derivatives will be used, understand the liquidity of the assets in the fund, and focus on whether the management fees are reasonable.

SEC’s Risk Chief to Target Hedge Funds with Exams

On March 8, 2016, the SEC announced the creation of the Office of Risk and Strategy within OCIE and appointed Peter Driscoll to run the new office as the chief risk and strategy officer. At the Investment Adviser Association’s annual compliance conference, Driscoll stated that the SEC intends to launch exams targeting hedge funds and focus specifically on portfolio management trading and back-office operations. OCIE continues to conduct exams on investment advisers that have never been examined and will begin to examine registered investment companies that have yet to be examined. Driscoll stated that OCIE anticipates meeting its goal of examining 25% of registered investment companies that have never been examined by the end of 2016.

SEC Official Predicts More Cyber Enforcement Cases

The SEC continues to focus on cybersecurity and how it can protect investors. The SEC’s work intersects with cybersecurity concerns in three chief ways:

• Registrants’ public disclosures involving cybersecurity risks;
• Including cybersecurity standards in regulations; and
• Attempting to ensure market integrity by combating manipulation schemes.

Although the SEC has yet to bring an enforcement action alleging a corporate cyber disclosure violation, the SEC has brought cases against firms relating to cyber market manipulation and failure to establish policies and procedures in advance of a security breach that compromised client information. Enforcement Director Andrew Ceresny has stated that the Staff intends to bring enforcement cases relating to cybersecurity in the future.

PwC Independence Questioned in Dispute with Regulators

Pricewaterhouse Cooper LLP (“PwC”) is currently in talks with regulators on whether it is too close to some of its mutual fund clients. The issue has come up in relation to the SEC’s Loan Rule. The Loan Rule states the auditors cannot serve clients that are at least 10% owned by a bank or any other large firm that lends the auditors money. PwC informed clients that one or more of its lenders own stakes of 10% of more in mutual funds audited by PwC, but that this did not compromise PwC’s independence. PwC told funds it has not violated the Loan Rule, but it is unclear whether the SEC will agree. If the SEC finds that PwC does not have the requisite independence, mutual funds will have to undergo new audits resulting in a “material adverse effect” on the fund and mutual funds will have to find new auditors in a limited market with only a few auditor options. PwC may not be the only auditor to have potentially violated the Loan Rule, putting mutual funds in a difficult position with no guidance from the SEC. In an extreme situation, funds may be blocked from issuing new shares to investors until they are re-audited, because new shares cannot be issued without audited financial statements. The SEC is still analyzing this issue and may resolve the matter by issuing new guidance for auditor relationships going forward.

SEC ENFORCEMENT ACTIONS

In Re: Robert W. Baird & Co., case number 2015045594601, before the Financial Industry Regulatory Authority (“FINRA”)

On April 18, 2016, Robert W. Baird & Co. (“Baird”) agreed to settle a FINRA claim by paying $2.1 million in restitution for a claim that Baird overcharged retirement plans and charities for their investments in mutual funds. Between July 2009 and May 2015, certain clients of Baird paid upfront sales charges for the purchase of Class A Shares1 of mutual funds when they were promised that they would not be charged an upfront sales charge. Baird also failed to properly supervise its financial advisers by not providing them with sufficient policies, procedures, or guidance relating to when sales charge waivers to retirement plans and charities for certain investors should be applied. Since Baird notified FINRA of its violations and agreed to cooperate and repay customers approximately $1.8 million in excessive fees and $300,000 in applicable interest, Baird was not subject to an additional penalty or fine.

In the Matter of TPG Advisors LLC, Adm. Proc. File No. 3-17216 (April 19, 2016)

TPG Advisors LLC, a registered investment adviser, and its owner and principal, Larry M. Phillips, were charged with violating Section 10(b) of the Exchange Act and Sections 206(1), 206(2), and 207 of the Investment Advisers Act by not abiding by the firm’s trade allocation policies. The firm’s trade allocation policies stated that trades be allocated in the most equitable manner possible. The SEC alleged that from January 2010 through August 2014 the firm did not abide by its trade allocation policy and favored six accounts held by four clients. Phillips placed trades in a master account without identifying any specific allocation. If the security could be bought and sold within the same day for a profit, that specific position would be closed in the master account and the profits would then be allocated to one of the six favored accounts. If the position could not profit within the same day, it was allocated to one of the disfavored accounts. The proceeding will be set for a hearing shortly.

In the Matter of Bruce A. Hartshorn, Adm. Proc. File No. 32075 (April 20, 2016)

Bruce A. Hartshorn (“Hartshorn”), the founder of Hartshorn & Co. Inc., a registered investment adviser, was charged with violating Section 10(b) of the Exchange Act and Section 201(1) of the Investment Advisers Act by not abiding by the firm’s trade allocation policies. The firm’s trade allocation policies stated that when it aggregated client orders, the firm would allocate the executions in a way that benefited all accounts equally. From January 2010 to March 2011, Hartshorn violated the firm’s trade allocation policy. For example, Hartshorn would purchase a block of securities in the firm’s omnibus account, and allocate the trades later in the day. When Hartshorn eventually allocated the trades, he placed trades that had positive first-day returns in propriety accounts and trades that had negative first-day returns in client accounts. Harshorn consented to the SEC’s order without admitting or denying the SEC’s findings and agreed to a cease-and-desist order, and to pay disgorgement, prejudgment interest, and a civil penalty totaling $189,552.20. Hartshorn has also been barred from the securities industry.

Christopher Zoidis et. al. v. T. Rowe Price Associates Inc., case number 4:16-cv-02289 (N.D. Ca.)

On April 27, 2016, investors filed a Complaint in California federal court against T. Rowe Price Associates Inc. for overcharging investment management fees. The Complaint alleges that T. Rowe Price’s Board, who annually approves the investment management fees, did not specifically assess the fees presented to them nor did they look at each fund’s peer group to confirm that the fees being charged were reasonable. The suit accuses T. Rowe Price of violating Section 36(b) of the Investment Company Act of 1940, as amended, a breach of fiduciary duty rule that requires if an investment adviser charges a fee so disproportionately large that it bears no relationship to the services rendered, the investment adviser will be held liable. The investors claim that T. Rowe Price owes a fiduciary duty to each fund and that duty was breached because investment management fees charged to customers over the years have doubled but there has not been an increase in the actual services performed by the investment manager. Investors are demanding that T. Rowe Price pay back into the funds the “excessive and unlawful” investment management fees the funds paid the investment firm.

In the Matter of Santos, Postal & Company, P.C., Admin. Proc. File No. 3-17238 (April 29, 2016)

A PCAOB registered audit firm, Santos, Postal & Company, and Joseph A. Scolaro, a C.P.A., were charged with violating Section 207 of the Investment Advisers Act and engaging in improper professional conduct. Section 207 of the Investment Advisers Act states, “It shall be unlawful for any person willfully to make any untrue statement of a material fact in any registration application or report filed with the SEC, or willfully to omit to state in any such application or report any material fact which is required to be stated therein.” From 2010 to 2011, Santos, Postal served as the audit firm to SFX Financial Advisory Management Enterprises, Inc., a registered investment adviser. In 2010 the audit firm’s report filed with the SEC contained a material misstatement related to account withdrawls that Santos, Postal confirmed was accurate. Scolaro, who served as the engagement partner, failed to consider fraud risk factors related to false reporting and the misappropriation of assets and to identify any risks regarding the firm’s compliance with the custody rule. Additionally he failed to comply with the adviser’s internal controls and the lack of segregation of duties and used insufficient sampling procedures relating to account balances when clients failed to return confirmations. Santos, Postal and Scolaro each consented to the entry of a cease-and-desist order and may not appear or practice before the SEC for, respectively, one year and five years, prior to applying for reinstatement. Additionally, the firm was ordered to pay disgorgement of $25,800 and prejudgment interest, and Scolaro had to pay a penalty of $15,000.

United States v. Tagliaferri, No. 15-536 (2d Cir. 2016)

On May 4, 2016, the U.S. Court of Appeals for the Second Circuit determined that making a criminal case for investment adviser fraud does not require proof of intent to harm clients. In 2014, James Tagliaferri was convicted of investment adviser fraud, securities fraud, wire fraud, and a violation of the Travel Act based on his actions as the head of the investment firm, TAG Virgin Islands. Tagliaferri failed to disclose over $1.7 million in fees received in return for investing client assets. Additionally, Tagliaferri was charged with engaging in “cross-trade conduct” by selling one client’s poorly performing assets to another client and collecting fees for those trades. During trial, the judge did not provide instructions to the jury that the government needed to show intent to harm and Tagliaferri was convicted in July 2014 and sentenced to six years in prison. On appeal of the issue of the trial judge’s failure to provide the aforementioned instruction, the court determined that the intent to harm is not an element of a criminal conviction for an investment adviser to be convicted of fraud.

In the Matter of Edgar R. Page and PageOne Financial Inc., Admin. Proc. No. 3-16037

On May 27, 2016, the SEC barred Edgar R. Page, the chairman and principal of PageOne Financial Inc., from practicing in the securities industry, and ordered him to disgorge $2.75 million. Page and PageOne were charged with violating the Investment Advisers Act, which prohibits fraud by investment advisers. Page advised his clients to invest in various private funds created by a real estate development and management company without disclosing that the company intended to acquire a portion of PageOne, under an agreement in which Page would help raise $20 million for the private funds. From March 2009 to September 2011, Page’s clients invested approximately $13-$15 million in the private funds which then made installment payments to PageOne of approximately $2.7 million. According to the SEC, “Page betrayed his clients’ trust and breached his fiduciary duties by failing to disclose–or to cause PageOne to disclose–the relationship with the fund manager, the payments either he or PageOne was receiving, or the terms of the acquisition.”

SEC v. Kingdom Legacy General Partner, LLC et al., case number 2:16-cv-00441 (June 7, 2016)

On June 7, 2016, Mark C. Northrop and his investment adviser, Kingdom Legacy General Partner LLC, which managed Kindgom Legacy Fund LLC, was charged with fraud for allegedly stealing
$3 million from investors through undisclosed fees. From December 2010 to September 2015, Northrop raised approximatly $10 million from investors through an investment offering. Northrop told investors that he charged a 2% mangement fee and kept 20% of investor profits. Instead he kept 40-50% of investor profits and made investors sign certain documents agreeing to the high fees. The SEC’s complaint charges Kingdom Legacy General Partner and Northrop with violations of the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940, and seeks permanent injunctions, disgorgement of ill-gotten gains plus prejudgment interest, and civil monetary penalties.

In the Matter of Morgan Stanley Smith Barney LLC, Adm. Proc. File No. 3-17280 (June 8, 2016)

Morgan Stanley Smith Barney, a registered broker-dealer and investment adviser, was charged with failing to comply with the Safeguards Rule that requires a broker-dealer and investment adviser registered with the SEC to adopt written policies and precedures reasonably designed to insure the security and confidentiality of customer information and records, protect against anticpated threats or hazards to those records and protect against unauthorized access or use. Information from approximately 730,000 Morgan Stanley customer accounts was compromised when a former employee downloaded the data to a personal account and it was hacked by a third party. The SEC placed blame on the bank because it failed to implement proper controls on two internal client data portals and failed to monitor employee access to the information over an extended period of time. Morgan Stanley consented to the entry of a cease-and-desist order and will pay a penalty of $1 million.

In the Matter of Mohammed Riad et al., Admin. Proc. No. 3-15141

On June 13, 2016, the SEC ordered Mohammed Riad and Kevin Timothy Swanson, former portfolio managers at Fiduciary Asset Management LLC, to pay fines due to their use of a hidden investment strategy that eventually led to the downfall of their closed-end mutual fund, Fiduciary/Claymore Dynamic Equity Fund. Riad and Swanson’s use of complex and risky derivative trading strategies to yield outsize returns ended up losing the fund more than $45 million in September and October 2008. The fund was liquidated the following year. The SEC stated that Riad and Swanson “made fraudulent misstatements and omitted material facts in a closed-end fund’s shareholders report regarding the fund’s use of new derivative instruments and their effect on the fund’s performance and risk exposure.” Riad and Swanson will each pay $130,000 and are prohibited from working in the field or engaging with investment professionals. Swanson was barred for two years and Riad received a lifetime ban, along with an order to return $128,000 in ill-gotten gains due to his greater involvement in the trading strategy.

United States v. Li, case number 15-cr-00870 (S.D.N.Y. 2016)

On June 13, 2016, Owen Li, the founder and portfolio manager of the hedge fund Canarsie Capital LLC, was sentenced to probation for making fictitious trades, lying to investors and investigators, and ultimately causing the fund to lose approximately $57 million in the span of a month. In March 2016, Li faced a potential sentence of five years in prison and was told to repay
$56.8 million to investors. Li’s sentence was mitigated because he surrendered himself to authorities and pled guilty once he recognized the fund was lost, demonstrating his actions were not motivated by a desire to enrich himself, but to protect Canarsie’s investments. Li also settled an SEC administrative case by agreeing to be barred from the securities industry as a sanction for his role in the fund’s collapse.

DEPARTMENT OF LABOR FIDUCIARY RULE UPDATE

Chamber of Commerce of the United States of America et al. v. Thomas E. Perez et al., case number 3:16-cv-01476 (N.D. Tx.)

On June 1, 2016, eight industry and trade groups filed a lawsuit disputing the Department of Labor’s fiduciary rule claiming that the Department surpassed its authority in creating the rule that will be harmful to retirement savers. The lawsuit seeks an injunction to stop the implementation of the final rule. The complaint alleges that the Labor Department “failed to properly analyze the costs and benefits of the rule” and that this suit is necessary to prevent the Labor Department from “exceeding the authority that was assigned to it by Congress.”

President Obama Vetoes Resolution Against Department of Labor Fiduciary Rule

On June 8, 2016, President Obama vetoed a resolution to kill the Deparment of Labor’s fiduciary rule, which was approved by the House of Representatives in April (234-183 vote) and the Senate in May (56-41 vote). President Obama stated, “This rule is critical to protecting Americans’ hard-earned savings and preserving their retirement security. The outdated regulations in place before this rulemaking did not ensure that financial advisers act in their clients’ best interests when giving retirement investment advice. Instead, some firms have incentivized advisers to steer clients into products that have higher fees and lower returns—costing American families an estimated $17 billion a year.” President Obama’s veto of the resolution to kill the Department of Labor’s fiduciary rule was successful as neither the House nor the Senate had a supermajority vote that would override a veto.

1. Class A Shares of mutual funds normally require customers to pay an initial sales charge upon the purchase of shares plus any annual fund expenses. Typically, these fees are paid as concessions to the broker-dealer, but in the case of retirement plans and charities most of these fees are waived.