United States: Investment Management Special Report - 2018-19 Compliance Developments & Calendar For Private Fund Advisers

Last Updated: October 12 2018
Article by Jason M. Daniel and Mereen Miran


Despite the new administration, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have both continued to make novel interpretations and to bring enforcement actions that break new ground.

Cryptocurrency Developments. There have been a number of developments in the cryptocurrency space as the law has started to catch up to the technology in 2018:

  • The SEC staff made official statements regarding when a token may be a security and may no longer be a security
  • The SEC continued to bring actions related to cryptocurrency offerings against market participants, including an adviser to a fund organized to invest in cryptocurrencies that was not structured to rely on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, and a website that acted as a broker and a dealer in cryptocurrency offerings and secondary trading
  • A court ruled that a particular cryptocurrency may be a security such that securities fraud claims may be brought
  • Another court ruled that a cryptocurrency may be a commodity so that the CFTC would have jurisdiction
  • The CFTC proposed an interpretation of what "actual delivery" constitutes for cryptocurrency forward contracts making it more difficult to trade in or offer cryptocurrency tokens in the spot markets on a delayed basis
  • The National Futures Association (NFA) required immediate notice to the NFA if a member planned to engage in cryptocurrency or cryptocurrency derivatives transactions
  • The NFA also required specified disclosure by its members to clients regarding cryptocurrency risks and regulation
  • The SEC continues to reject the listing of exchange-traded funds that hold cryptocurrency.

In addition to the above, the SEC, the U.S. Department of the Treasury ("Treasury") and their respective staffs are still trying to determine how their current rules apply to cryptocurrency. The SEC staff sent a sweep letter to inquire into the current practices of investment advisers regarding cryptocurrencies, including with respect to custody practices and personal trading rules and valuation practices. The Treasury released a report on July 31, 2018 making several recommendations regarding emerging financial technologies (Fintech)—including cryptocurrencies—for anti-money laundering (AML) and counter- terrorism financing (CTF) purposes. However, unlike the SEC, the CFTC, the NFA and the Treasury's Financial Crimes Enforcement Network (FinCEN), the Internal Revenue Service (IRS) has not published new specific guidance since 2014.

For further information regarding cryptocurrency, see the alert entitled, "Developments in Cryptocurrency in 2018" available here.

Advertising. The SEC continues to focus on investment adviser misrepresentations in communications with potential clients or investors. On July 10, 2018, the SEC announced settlements involving improper testimonials on social media against registered investment advisers and their registered representatives. The two investment advisers hired the same marketing consultant, who contacted their advisory clients and solicited positive testimonials for publication on the firm websites, Google and other social media.1 In addition, one of the firms published videos on its website and YouTube containing 2 these settlements demonstrates the SEC's concerns about the potential for investment y seeking out and "cherry-picking" positive statements from its clients.

The SEC also brought and settled an action against a registered investment adviser for including back-testednumbers in its advertisements. Beginning in 2003, the adviser used a mix of fundamental and quantitative analyses in making its investment recommendations.3 The adviser included performance information labeled as "hypothetical" using the quantitative model developed in 2003 to generate back-tested performance for the period of 1995 to 2003. The SEC pursued the adviser despite the fact that the presentations were clearly labeled as "hypothetical" (instead of back-tested) and were exclusively made to institutional clients. The SEC also pursued the adviser for its ambiguous responses to a "request for proposal" that could be understood as claiming that it used quantitative inputs since 1995 instead of starting in 2003.

Quantitative Trading. The SEC also brought and settled an enforcement case against a sub-adviser to several registered investment companies (RICs) for launching a new quantitative investment system without adequate controls and failing to disclose that it ceased to use the system when it discovered the errors. The SEC also brought and settled claims against the adviser to the funds for, among other violations, failing to perform adequate diligence on the sub-adviser and for failing to disclose issues to the board or investors after being discovered.

The sub-adviser hired a recent MBA graduate who had no experience with modelling to design a new quantitative model. The sub-adviser's senior staff did not provide the junior analyst any "meaningful guidance, training or oversight" in modeling. The sub-adviser's internal audit function discovered in 2011 that models were not independently validated, which was about the same time that a fund with the new model was being offered. Despite being aware of the failure to validate the models, management decided to proceed with the new fund and later launched other funds based on the same system still without having validated the model. During later validation of the model, the sub-adviser determined that models included numerous errors in logic, methodology and math, and were not fit for use. The sub-adviser subsequently no longer used the models or largely ignored them. The investment adviser learned of the model's errors in 2014 and recommended terminating the sub-advisory arrangement in 2015 to the RICs' boards without informing them of the errors discovered or the reasons for the terminations.4 The SEC brought actions for violations of the duty to supervise, the advertising rule, the compliance policies rule and other violations of the Investment Company Act of 1940.

Cross Trades and Principal Transactions. The SEC pursued a number of cases on cross trades and transactions between clients and principals in 2018, focusing particularly on the price used and the depth of the trading markets. In the first action, the SEC brought and settled an action against an investment adviser that priced cross trades of bonds using the bid price (instead of a midpoint between the bid and the ask spread) and challenged the broker to increase the bid prices.5 In the second action, the SEC pursued an investment adviser and its principal for the principal's purchase of interests in advisory clients in connection with the wind down of the fund client using the previous December's net asset value (NAV). The SEC claimed that the use of the previous December's NAV for the purchase despite subsequently receiving indications that the NAV had increased without informing the limited partners of the increase was a violation of the Advisers Act and related rules. 6 In the third action, the SEC brought an action against the investment adviser to a registered investment company for separate open market transactions involving the registered fund and a private fund client that were conducted one hour apart and using differing brokers. Despite the details of the trade, the SEC believed that, due to the relative illiquidity of the market, the trade was a cross trade under the Investment Company Act of 1940.  In the final action, the SEC pursued a registered investment adviser for (i) investing one of its fund clients into another of its fund clients and receiving a fee based on that acquisition without disclosure and consent and (ii) selling receivables from a fund wholly owned by the adviser to another fund client without obtaining disclosure as a principal transaction. The SEC pursued the investment adviser despite the subject securities being receivables relating to defaulted consumer debt, as it viewed the receivables as securities for the purposes of this action.7

Advisory Fee Computations. The SEC's Office of Compliance Inspections and Examinations (OCIE) published a risk alert in April of 20188 describing repeated compliance failures in the calculation of fees in advisory fees and adequacy of policies. Specifically, the OCIE references frequent deficiencies relating to:

  • Using a valuation process that differs from the relevant governance agreement, or improperly using original cost instead of current market value
  • Billing fees in a manner contrary to the agreement by billing in advance, with improper frequency or using an improper rate
  • Improperly computing advisory fees, through failing to apply the discounts to which the adviser agreed
  • Failing to disclose that there were mark ups over expenses or certain fees
  • Misallocation of expenses—including distribution and marketing expenses or regulatory filing expenses—to the client (instead of the manager) in contravention of the agreement with the client.

This alert demonstrates OCIE's focus on recalculating amounts charged. As part of its focus on fees, the SEC continued its practice of pursuing investment advisers to private equity funds relating to the acceleration of monitoring fees.

Best Execution. OCIE published another alert in July 2018 regarding common deficiencies in investment advisers' policies and practices to ensure best execution obligations.9 Specifically, OCIE highlighted the following issues:

  • Investment advisers failing to document having evaluated the execution performance at the time of selecting a broker-dealer or on a periodic basis
  • Failing to provide an informed review of those employees with knowledge of broker-dealer performance—such as traders—or failing to adequately compare broker-dealers
  • Failing to fully disclose execution practices or impacts of soft dollar arrangements
  • Insufficiently tailoring policies and procedures or failing to follow them.

Mergers and Acquisitions. The SEC brought and settled two enforcement actions relating to mergers and acquisitions transactions in July of 2018. The first action—against a Canadian acquirer of 16.5% of a New York Stock Exchange-listed issuer—involved failure to file a Schedule 13D on the required 10- day timeframe as part of its acquisition of the company.10 In the second action, the SEC brought and settled an unusual enforcement action against an issuer for repeatedly failing to provide its unit holders with a recommendation of whether to accept or reject multiple tender offers in violation of the tender offer rules.11

SEC Withdraws Proxy Adviser No-Action Letters. On September 13, 2018, the SEC announced—in a sudden reversal—that it was withdrawing two 2004 no-action letters that provided guidance on advisers' use of proxy advisers who may receive compensation and a discussion of such proxy adviser's conflict of interest.12 The SEC provided no reason for the sudden withdrawal, except that this subject will be discussed at a proxy roundtable discussion to ted by the SEC in November of this year. In light of this withdrawal of guidance, advisers are warned to use caution if and when proxy advisers are aged.

Failure to Supervise Repeat Offender. The SEC also brought and settled an enforcement action against an adviser for failing to adequately supervise its employee, whom it was aware was sharing confidential research, holdings and trading information with his wife, the founder of a separate adviser.13 Although the adviser had confidentiality policies and procedures in place generally, it did not implement subsequent reasonably-tailored policies and procedures once it repeatedly learned of its employee's continuous, unrelenting behavior.

Inadvertent Custody Clarification. In February 2017, the staff of the Division of Investment Management (the "Division") issued guidance14 interpreting "custody," for purposes of the custody rule, to include deemed authority under a custodial agreement that does not explicitly restrict the adviser from instructing the custodian to disburse or transfer funds or securities. The Division viewed a registered investment adviser as having custody even if the investment advisory agreement between the investment adviser and its client prohibited the adviser from withdrawing assets in circumstances in which the adviser was not a party to and had not seen the custodial agreement.

In June of 2018, however, the Division limited the scope of its prior guidance.15 The update clarifies that a registered investment adviser's custody hinges on the registered investment adviser's knowledge of the rights under the applicable custody agreement or constructive knowledge through receipt of the custodial agreement. Advisers that do not have a copy of the agreement or do not know or have reason to know about the agreement are not deemed to have custody due to the rights under the custodial agreement, so long as the adviser recommended, requested or required a client's custodian.

Referral Fees. The SEC brought and settled enforcement actions against two investment advisers that failed to disclose to their clients that they received referral fees from other entities. In the first case, the offending party received "payments . . . based on the total amount of . . . client assets placed or maintained in certain funds advised by the Third Party Advisers." This agreement "was not disclosed, and was in contravention of investment management agreements of two clients." The SEC also charged the adviser with violations of Sections 206(4) and 204(a) for failure to "implement policies and procedures reasonably designed to detect and prevent conflicts of interest and . . . to maintain accurate books." 16

The second case involved an investment adviser that recommended third-party products to its clients but did not disclose fees it received when clients used those products. The adviser also "made statements concerning the benefits" of the recommended products "that were materially misleading or incomplete."17 While the first case resulted in a relatively minor fine, the second adviser was forced to give notice to its clients of the proceedings, retrain its staff, submit to independent reviews and pay an $8 million fine.

Investment Advisers' Fiduciary Duties. As part of a group of three proposals regarding fiduciary obligations of investment advisers and broker-dealers, the SEC recently proposed a new interpretation (the "Proposed Interpretation")18 of the fiduciary duties of investment advisers. Although not yet law, the on the fiduciary duties of advisers and will likely be relied upon in future cases and enforcement actions Proposed Interpretation is not approved by the SEC.


1 Advisers Act Release No. 4962 (Jul. 10, 2018) available here; Advisers Act Release No. 4961 (Jul. 10, 2018) available here; Advisers Act Release No. 4963 (Jul. 10, 2018) available here; Advisers Act Release No. 4964 (Jul. 10, 2018) available here.

2 Exchange Act Release No. 83613, Advisers Act Release No. 4965 (Jul. 10, 2018) available here.

3 Advisers Act Release No. 4999 (Aug. 31, 2018) available here.

4 Securities Act Release No. 10539, Advisers Act Release No. 4996 (Aug. 27, 2018) available here.

5 Advisers Act Release No. 4983 (Aug. 10, 2018) available here.

6 Advisers Act Release No. 5001 (Sep. 7, 2018) available here.

7 Advisers Act Release No. 5041 (Sept. 21, 2018) available here.

8 Office of Compliance Inspections and Examinations "National Exam Program Risk Alert" (Apr. 12, 2018) available here.

9 See Office of Compliance Inspections and Examinations "National Exam Program Risk Alert" (Jul. 11, 2018) available here.

10 Exchange Act Release No. 83626 (Jul. 13, 2018) available here.

11 Exchange Act Release No. 83627 (Jul. 13, 2018) available here.

12 See IM Information Update 2018-02 "Statement Regarding Staff Proxy advisory Letters" (Sep. 2018) available here.

13 Advisers Act Release No. 4819 (Dec. 5, 2017) available here. The SEC brought and settled separate actions, as well, with the adviser's employee and his wife, with whom he shared the adviser's confidential information.

14 See IM Guidance Update 2017-01 "Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority" (Feb. 2017) available here.

15 See Division of Investment Management Staff Responses to Questions About the Custody Rule, Questions II.11 & II.12 available here.

16 Advisers Act Release No. 4932 (June 4, 2018) available here. We note that no case was brought on failure to register as a broker-dealer, but the adviser was affiliated with a broker-dealer.

17 Advisers Act Release No. 4933 (June 4, 2018) available here.

18 See "Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation," Advisers Act Release 4889 available here.

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.

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