This Newsletter discusses recent key guidance releases, regulatory changes, noteworthy news and certain upcoming compliance deadlines.

SEC GUIDANCE AND UPDATES

SEC 2017 Exam Priorities. In January, the SEC released its Examination Priorities for 2017 (the “Priorities”). The Priorities show a continuing focus on protecting retail investors and minimizing system-wide risks. Specific interest areas are cybersecurity, anti-money laundering compliance, “roboadvisers”, and investment managers who have yet to be examined. Notably, private fund advisers remain an examination priority. Additional information about robo-advisers and a recent anti-money laundering enforcement action are described below.

With cybersecurity clearly on the SEC’s radar, advisers are encouraged to continually review and update their cybersecurity compliance policies. Many advisers employ “off-the-shelf” cybersecurity policies having procedures that are irrelevant to their organization and operations. So advisors should tailor their cybersecurity policies to their specific business operation, and then periodically review and test their related “incident response plans,” that detail how the advisers would respond to a data breach. Additional information about incident response plans, applicable to advisers and other businesses alike, can be found here.

SEC Custody Rule Clarifications. In February, SEC published additional guidance on the “Custody Rule” of the Investment Advisers Act of 1940, (the “Advisers Act”). The guidance notably addressed confusion regarding the application of the Custody Rule to Standing Letters of Authorization (“SLOAs”) and first-person transfers. A SLOA instructs a client’s qualified custodian to transfer the client’s assets to a designated third-party recipient, while a first person transfer occurs when a client authorizes its adviser to move funds to another account held in the client’s name.

Under the Custody Rule, any adviser who holds custody over a client’s assets is required to undergo a surprise examination each year, subject to certain exceptions. A SLOA has been deemed under certain circumstances to impute custody to the adviser, thereby triggering the surprise examination requirement. The SEC’s recent guidance clarifies that some SLOAs would not impute custody to the adviser if certain representations are included in the SLOA, such as: (i) the client provides a written, signed instruction to the qualified custodian that includes the third-party recipient’s name and address or account number at the custodian; (ii) the client’s custodian verifies the client’s authorization and provides a transfer of funds notice to the client promptly after each transfer; and (iii) the adviser has no authority or ability to designate or change the identity, address, or any other information about the third-party recipient.

Adviser Action Item - Amend existing SLOAs to ensure the appropriate representations are included. Additional information about the appropriate SLOA representations can be found here.

A first-person transfer occurs when a client authorizes its adviser to move funds to another account held by the client. Under the Custody Rule, an adviser does not have custody if the client’s authorization to make such first-person transfers describes the client’s account(s) to which such transfers may be made. The SEC’s recent guidance clarifies that such authorization should describe with specificity such accounts, including account numbers. A blanket authorization is insufficient to avoid custody.

Adviser Action Item - Review advisory agreements and/or instructions from clients to ensure transfer authorizations include the specific accounts to which transfer will be made. Additional information about the Custody Rule and its application to first-person transfers can be found in Section II.4 of this SEC FAQ.

SEC Robo-Adviser Updates. In February, the SEC published a Guidance Update focused on “robo-advisers” and compliance under the Advisers Act. Robo-advisers, according to the SEC, “use innovative technologies to provide discretionary asset management services to their clients through online algorithmic-based programs.” Most robo-advisers utilize questionnaires to determine appropriate investment allocations for their clients and use automated trading software to implement and maintain those allocations.

The SEC’s guidance focused on three areas:

1. Client Disclosures. The SEC noted that, since many robo-advisers offer little, if any, human interaction to their clients, the adviser’s disclosures may be a client’s sole source of information when making an investment decision. A robo-adviser’s disclosures, according to the SEC, should include a detailed description of its business model and the scope of the advisory services provided to clients, and be presented in a manner that effectively and clearly communicate the information being disclosed.
2. Suitable Investment Advice. Many robo-advisers rely on questionnaires to determine appropriate investment allocations, strategies, and suitability for their clients. The SEC noted that many of the questionnaires they examine neither solicit sufficient information for the adviser to provide suitable recommendations, nor “flag” inconsistent client answers provided. Further, notwithstanding the robo-adviser’s recommendations based on client questionnaires, many robo-advisers permit clients to select their own investment allocations and strategies. This results in the robo-adviser employing investment allocations and strategies that it believes are not suitable for clients. Each of these problems could amount to a violation of the robo-adviser’s duty to act in the clients’ best interests.
3. Compliance Concerns. A robo-adviser’s compliance program must consider and account for its reliance on algorithms and unique business model. An appropriate compliance program should address, among other areas, the testing of the algorithmic code, the disclosure to clients of any changes to that code, the oversight of third parties involved in the development of that code, and the use of social media for marketing purposes.

Top Five OCIE Compliance Areas. In February, the SEC’s Office of Inspections and Examinations (“OCIE”) released a list of the five compliance areas most frequently identified during examinations and in the resulting deficiency letters during the past two years. Those five areas are:

1. The Compliance Rule – Failure to develop and adhere to a suitable compliance manual based on the adviser’s actual business practices;
2. Regulatory Filings – Filings are late or contain material inaccuracies or omissions;
3. Custody – Failure to recognize when the adviser has custody, as well as inadequate surprise examinations;
4. Code of Ethics – Failure to comply with applicable personal securities trading restrictions; and,
5. Books and Records Rule – Failure to maintain all required books and records, as well as material inaccuracies or omissions.

The full OCIE release can be found here.

REGULATIONS WITH RAMIFICATIONS

DOL Suspends Enforcement of Revised Fiduciary Rule. As we reported in our 2017 Annual Update, President Trump ordered a review of the Department of Labor’s (“DOL”) proposed revisions to the “Fiduciary Rule” that expands who is considered a fiduciary under the Employee Retirement Income Security Act of 1972. The Fiduciary Rule, which would impose a higher “best interest” standard of care on investment advisers to certain retirement plan clients, is set to become effective on April 10, 2017. The DOL has indicated that it may be required to delay the effective date by 60 days such that it can finish its mandated review. This has created significant uncertainty with respect to whether firms would be expected to comply with the Fiduciary Rule by April 10, 2017 in light of the potential 60-day delay. In response to such confusion, the DOL issued a bulletin on March 10, 2017 notifying firms that it would not, “in the short term,” pursue enforcement of the Fiduciary Rule, providing temporary relief while the DOL finalizes its review. We will continue to monitor this situation closely and advise clients of important developments. Additional information about the Fiduciary Rule can be found here and about the DOL’s bulletin can be found here and here.

ENFORCEMENT MATTERS

SEC Charges New York Brokerage Firm and CCO with AML Violations. The SEC recently charged a New York-based broker-dealer, Windsor Street Capital, L.P. (f/k/a Meyers Associates, L.P.) and John David Telfer, who acted as Windsor’s Chief Compliance and Anti-Money Laundering Officer for three-years, alleging serious Anti-Money Laundering violations. The SEC charged Windsor and Telfer personally for their failures to file Suspicious Activity Reports with the U.S. Treasury Department’s Financial Crimes Enforcement Network related to two customers’ sales of $24.8 million in penny stocks. In support of the charges, the SEC points to several “red flags” presented by the transactions, which took place over a four-year period, including: (i) simultaneous trading activity in both customers’ accounts; (ii) a pattern of depositing shares and quickly liquidating them; and (iii) the suspicious timing of stock issuers’ press releases and online promotional campaigns with the stock sales.

As we noted in our 2017 Annual Update, registered investment advisers are expected to soon be subject to many of the AML rules and regulations that currently apply to broker-dealers like Windsor. This action highlights the SEC’s focus on this area and the shortcomings that can lead to enforcement. Additional information about the enforcement action can be found here.

Who is a Whistleblower Now? In March, a decision from the Ninth Circuit Court of Appeals held that the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”) protects “whistleblowers” who disclose only internally (i.e., to their employer) perceived corporate wrongdoing. This expands the scope of Dodd-Frank’s whistleblower protections – not only do they apply to disclosures made to external parties (such as a government regulator), they also apply to internal disclosures. In the case, an employee was fired after internally reporting alleged securities law violations, but before making a similar report to the SEC. The Ninth Circuit ruled that firing the employee was considered a “retaliation” in violation of Dodd-Frank’s whistleblower protections.

This ruling conflicts with other rulings on this subject from the Fifth Circuit Court of Appeals, making United States Supreme Court review more likely. Additional information about the case and ruling can be found here.

Selected Q2 2017 Compliance Calendar

The following compliance calendar includes selected upcoming deadlines for SEC-registered investment advisers and is not indented to be complete. State-registered investment advisers may be subject to additional or different deadlines. Please contact us to discuss which deadlines are applicable to you.

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