YCC: What You Need to Know – Quarterly Update – October 2024

P2P: The SEC settled with an investment adviser for $95,000 for violations of the SEC’s “Pay-to-Play Rule,” Rule 206(4)-5 for receiving payment of advisory fees from a government entity investor in a private fund following an individual, who later became a supervised person of the investment adviser,  making a political contribution to an incumbent for elected office in the State of Michigan, which office had influence for hiring investment advisers for a state public pension plan in Michigan. 

Lesson Learned: The SEC takes a strict view on P2P violations. It is interesting to see that the individual sought to return the contribution; however, the return of the contribution did not qualify for the relief offered under the rule due to the amount and timing. Also interesting to see that the investment made by the government entity was prior to the associate joining the firm and that the government entity was not in a position to add to its investment thus removing the potential for conflict.

Insider Trading: The SEC settled charges against a registered investment adviser for $1.8 million for failing to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information (MNPI) concerning the adviser’s trading of collateralized loan obligations (CLOs). The adviser received MNPI about companies whose loans were held in the CLOs that the adviser traded. Without finding that insider trading occurred, the SEC also settled with a registered investment adviser for $1.5 million for failing to establish, maintain, and enforce policies and procedures reasonably designed to prevent the use of MNPI relating to its participation on ad hoc creditors’ committees, where participants are potentially in the position of receiving MNPI or engage advisers who are often tasked with analyzing debtors’ MNPI. 

Lesson Learned: “Fund managers – including those with multiple business lines or strategies – must consider how they may come into possession of MNPI and then adopt and implement reasonable policies and procedures around those risks,” said Andrew Dean, Co-Chief of the Enforcement Division’s Asset Management Unit. “Among other things, advisers must evaluate how their roles as lenders could expose them to MNPI that may relate to their CLO trading positions.” “Investment advisers who regularly enter into formal or informal relationships with companies or interact with financial advisers or other consultants who do so, including through ad hoc creditors’ committees, must take into consideration those circumstances when designing their material nonpublic information policies and procedures,” said Osman Nawaz, Chief of the Enforcement Division’s Complex Financial Instruments Unit. “We will continue to monitor such relationships and, where appropriate, bring action.”  

Cybersecurity: The SEC settled charges against a transfer agent for $850,000 for failing to ensure that client securities and funds were protected with the loss of more than $6.6 million of client funds as a result of two cyber intrusions. 

Lesson Learned: “[The transfer agent] failed to provide the safeguards necessary to protect its clients’ funds and securities from the types of cyber intrusions that have become a near-constant threat to companies and the markets,” said Monique C. Winkler, Director of the SEC’s San Francisco Regional Office. “As threat actors become more sophisticated in the cyber space, transfer agents must act to implement and maintain effective safeguards and procedures around client assets.”

Marketing Rule: The SEC settled charges against a registered investment adviser for $430,000 for advertising hypothetical performance on its public website without adopting and implementing reasonable policies and procedures required under the Marketing Rule. The SEC also settled with nine investment advisers in an ongoing sweep into Marketing Rule violations for $1.2 million for making unsubstantiated claims or using testimonials, endorsements, or third-party ratings lacking required disclosures. 

Lesson Learned: It seems the hypothetical performance case should be a lesson that was learned after other similar actions. “The Marketing Rule’s provisions regarding truthfulness, substantiation, and disclosure are critical to protecting investors. The advertisements at issue in each of these actions violated the Marketing Rule and posed a serious risk of misleading investors,” said Corey Schuster, Co-Chief of the SEC Division of Enforcement’s Asset Management Unit.  “Investment advisers must comply with all aspects of the Marketing Rule, and we will continue to hold them accountable when they fail to do so.”

Cash Sweeps: The SEC is investigating certain cash sweep programs regarding the rate of interest on cash balances swept into affiliate program banks. 

Lesson Learned: Several brokerage firms have also been hit with lawsuits claiming that the firms breached their fiduciary duties by failing to pay clients reasonable interest rates. Consider appropriate disclosures for investment advisory clients that are participating in cash sweep programs.

Enforcement Coordination: The SEC’s Division of Enforcement launched an Interagency Securities Council to coordinate enforcement efforts across federal, state and local agencies.

Whistleblowing: The SEC settled with a registered investment adviser for $500,000 for entering into employment agreements with potential hires and a former employee that contained non-disclosure provisions that made it more difficult for reporting potentials securities law violations to the SEC. The SEC also settled with three affiliated registrants for $240,000 for impeding brokerage and advisory clients from reporting securities law violations to the SEC. The firms asked 11 retail clients to sign confidentiality agreements, that contained provisions restricting reporting to securities regulators, in connection with payments made to the clients to cover losses caused by the firms’ alleged breaches of federal/state securities laws. The SEC also settled with seven public companies for $3 million in combined penalties for using employment, separation, and other agreements that violated rules prohibiting actions to impede whistleblowers from reporting potential misconduct to the SEC. 

Lesson Learned: While the agreements permitted the candidates to respond to requests for information from the Commission, it required notification to the firm of any such request and prohibited responding to requests arising from a candidate’s voluntary disclosure. The firm also entered into a settlement agreement with a former employee who intended to report alleged securities violations to the SEC. The settlement agreement permitted reporting potential securities violations to government agencies, including the SEC; however, it required the former employee to affirm that he/she had not done so, was not aware of facts that would support an investigation; and would withdraw any statements already made that might support an investigation. These provisions violated Rule 21F-17(a), the whistleblower protection rule. “Whether through agreements or otherwise, firms cannot impose barriers to persons providing evidence about possible securities law violations to the SEC…,” said Corey Schuster, Co-Chief of the Division of Enforcement’s Asset Management Unit. “Even agreements that contain carve-out language allowing people to voluntarily report to the SEC can be violative if restrictive language in a separate provision impedes voluntary reporting to the Commission staff.” “Pure and simple, investors need to be able to report complaints or evidence of wrongdoing to the SEC without impediment,” said Schuster. “We will continue to hold firms accountable for putting roadblocks between us and their investors.” YCC is also aware of deficiencies cited under the whistleblower protection rule for private fund confidentiality provisions – apparently a new area of focus. Also interesting: “We are already starting to see the SEC, in examinations, pressing more on the types of issues that the private fund adviser rule changes would have addressed,” said former SEC regulator Aaron Schlaphoff, now a partner at Paul Weiss.

SEC Filings: The SEC levied more than $3.8 million in penalties against 23 entities and individuals for failures to timely report information about their holdings and transactions in public company stock in sweep of late beneficial ownership and insider transaction reports, including Schedules 13D and 13G and Forms 3, 4, and 5. Two public companies were also charged for contributing to filing failures by their officers and directors and failing to report their insiders’ filing delinquencies, as required. Charges also included failures to file Forms 13F. The SEC also charged 11 institutional investment managers for failing to report certain securities holdings on Form 13F. Two firms were also charged with failing to report large trader transactions on Form 13H. Nine of the firms agreed to settlements of more than $3.4 million in combined penalties and two of the firms who self-reported were assessed no civil penalties. 

Lesson Learned: “To make informed investment decisions, shareholders rely on, among other things, timely reports about insider holdings and transactions and changes in potential controlling interests,” said Thomas P. Smith, Jr., Associate Regional Director of the SEC’s Division of Enforcement. “Today’s actions are a reminder to large investors that they must commit necessary resources to ensure these reports are filed on time.” “The integrity of the securities markets depends largely on firms providing accurate, timely information about their securities holdings and trading activity,” said Jason Burt, Director of the Denver Regional Office. “These resolutions illustrate how seriously the Commission takes non-compliance as well as the benefits a firm may derive from self-reporting its non-compliance.”

Client Option Mandates: The SEC settled with two investment advisers for $9.3 million for exceeding clients’ designated investment limits over a two-year period which resulted in clients paying higher fees, being subjected to increased market exposure, and incurring investment losses. The firms were charged with violations of Section 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7 thereunder. 

Lesson Learned: “In this case, two investment advisers allegedly sold a complex options trading strategy to their clients, but failed to abide by basic client instructions or implement and adhere to appropriate policies and procedures,” said Mark Cave, Associate Director of the SEC’s Enforcement Division. “Today’s action holds [the firms] accountable for dropping the ball in executing these basic duties to their clients, even as their clients’ financial exposure grew well beyond predetermined limits.”

Cross Trades and Valuation: The SEC settled with a registered investment adviser for $79.8 million for overvaluing illiquid collateralized mortgage obligations held in 20 client accounts, including 11 retail mutual funds, and for executing hundreds of cross trades between advisory clients that favored certain clients over others in violation antifraud and compliance provisions of the Investment Advisers Act and Investment Company Act. 

Lesson Learned: “It is alarming that a fiduciary took advantage of retail mutual funds it advised and executed unlawful cross trades to mitigate its overvaluation of fund assets,” said Eric I. Bustillo, Director of the SEC’s Miami Regional Office. “Utilizing a third-party pricing service does not negate an investment adviser’s obligation to value assets accurately.”

Misleading Strategy: The SEC settled with a registered investment adviser for $300,000 and was required to retain an independent compliance consultant for making misleading statements and for compliance failures related to the execution of its “biblically responsible investing” strategy for failing to adopt written policies and procedures setting forth a process for evaluating companies’ activities as part of its stated investment process. 

Lesson Learned: “Investors must be able to rely on advisers acting consistently with their represented investment process or strategy,” said Corey Schuster, Co-Chief of the Asset Management Unit in the Division of Enforcement. “Here, [the firm’s] investment screening process was not what it represented to investors, resulting in it making investments that were contrary to its stated investment criteria.”

Hedge Clauses: The SEC settled with a private fund adviser for $65,000 for failing to comply with the custody rule and for using impermissible liability disclaimers in its advisory and private fund agreements in violation of sections 206(2) and 206(4) of the Advisers Act and Rules 206(4)-2 and 206(4)-7 thereunder. The SEC found that the firm failed to timely distribute annual audited financials to investors and that certain agreements included liability disclaimers, “hedge clauses,” that could lead a client to incorrectly believe that they had waived non-waivable causes of action against the investment adviser. Certain of the disclaimers also contained misleading statements regarding the investment adviser’s otherwise unwaivable fiduciary duty. 

Lesson Learned: “The SEC remains focused on the custody rule, which is vital to investor protection,” said Andrew Dean, Co-Chief of the SEC Enforcement Division’s Asset Management Unit. “In addition, all advisers, including private fund advisers, should be mindful about including hedge clauses in agreements. Even for private fund advisers, in certain circumstances, such clauses could be misleading.”