United States: A Compilation Of Enforcement And Non-Enforcement Actions - 31 March 2016

NON-ENFORCEMENT

Remember to Update Your Risk Disclosure on an Ongoing Basis

The staff of the Securities and Exchange Commission (SEC) issued guidance reminding mutual funds, exchange traded funds, and other registered investment companies of the importance of reviewing their risk disclosures on an ongoing basis and considering whether these disclosures remain adequate in light of current market conditions.

Key Takeaways: The following are key considerations for investment companies:

  • Monitor market conditions and their impact on fund risks on an ongoing basis and assess the impact of changing conditions on the fund and the risks associated with its investments. Funds should routinely engage in this practice as a normal part of day-to-day operations.
  • Assess whether fund risks have been adequately communicated to investors in light of current market conditions. If a fund determines that changed market conditions have affected the risks associated with the fund, the fund should assess the significance of the change and whether it is material to investors. If it is material, a fund should consider whether its existing disclosures are adequate in light of the changed conditions.
  • A fund that determines that changes in current market conditions have resulted in changes to the fund's risks that are material to investors, and that its current disclosures do not adequately communicate the changes, should update its communications to investors. Means of communication to be considered include the prospectus (which, for example, would be updated when the fund determines that the risk disclosure in its prospectus would be materially misleading) and shareholder reports, as well as less formal methods, such as website disclosure and letters to shareholders.
  • A fund that exposes investors to market, credit, or other risks, and whose name suggests safety or protection from loss, should reevaluate the name, as appropriate, to eliminate the potential for investor misunderstanding.
  • A fund that uses investment strategies that employ derivatives should disclose material risks relating to volatility, leverage, liquidity, and counterparty creditworthiness associated with the fund's trading and investments in derivatives. This disclosure should be tailored to the specific derivative instruments in which a fund invests or will invest principally.
  • A fund's adviser should consider providing information to the fund board on the steps taken by the adviser to evaluate fund risk disclosures and consider whether changes are appropriate to respond to changing market conditions or other developments.

Summary: Clear and accurate disclosure of the risks of investing in funds is important to informed investment decisions and, therefore, to investor protection. A mutual fund, for example, is required to summarize the principal risks of investing in the fund, including the risks to which the fund's portfolio as a whole is subject and the circumstances reasonably likely to affect adversely the fund's net asset value, yield, and total return, in both its summary prospectus and statutory prospectus.

The guidance is intended to address another important aspect of fund risk disclosure, namely, the changes in a fund's susceptibility to risk that may result from changes in market conditions and the need for funds to review and assess risk disclosures in light of changing market conditions. Degree of risk is dynamic in nature rather than static; it changes in response to market conditions, and different risks may be heightened or lessened at different points in time. As a result, a fund may determine that risk disclosure that may have been adequate at one time may need to be reconsidered in light of new or changed market conditions.

If a fund determines that its risk disclosure is not adequate, the SEC believes that the fund should consider the appropriate manner of communicating changed risks to existing and potential investors, for example, in the prospectus, shareholder reports, fund website, and/or marketing materials.

SEC Guidance on Payments to Financial Intermediaries

The SEC released guidance from the staff of the Division of Investment Management on issues that may arise when mutual funds make payments to financial intermediaries that provide shareholder and recordkeeping services for investors whose shares are held in omnibus and networked accounts maintained with mutual funds. In particular, the guidance addresses whether a portion of those payments are being used to finance distribution and therefore, if paid by a fund, must be paid pursuant to Rule 12b-1 under the Investment Company Act of 1940. The guidance characterizes these payments as "sub-accounting fees," although it notes that they may also be characterized as sub-transfer agent, administrative, and other shareholder servicing fees.

Key Takeaways: The following are key considerations for the board of directors of a mutual fund:

  • Funds should ensure they have policies and procedures reasonably designed to prevent violations of Section 12(b) of the Investment Company Act and Rule 12b-1 regardless of whether they have Rule 12b-1 plans.
  • When the recipient of payments for services also finances distribution (for example, an intermediary that distributes fund shares), it raises a question as to the direct or indirect use of fund assets, requiring relevant input from the investment adviser and other relevant service providers and the informed judgment of the board.
  • The board should have a process in place reasonably designed to assist directors in evaluating whether a portion of fund-paid sub-accounting fees is being used to pay directly or indirectly for distribution.
  • The board should ensure that the investment adviser and other relevant service providers provide sufficient information to inform the board of the overall picture of intermediary distribution and servicing arrangements for the funds, including how the level of sub-accounting fees may affect other payment flows (such as revenue sharing) that are intended for distribution.
  • The board should carefully review the following items:

    • distribution-related activity that is conditioned on the payment of sub-accounting fees;
    • the lack of a Rule 12b-1 plan;
    • the use of tiered payment structures, in which payments typically are made first from Rule 12b-1 fees, then sub-accounting fees, and finally by the investment adviser or an affiliate;
    • a lack of specificity as to the services provided in exchange for sub-accounting fees, or payments for both sub-accounting and distribution that are bundled into a single contract;
    • taking distribution and sales benefits into account when recommending, instituting, or raising sub-accounting fees;
    • the use of disparate sub-accounting payment rates to intermediaries that may be providing substantially the same set of services; and
    • payments to intermediaries for strategic sales data.

Directors' Outside Relationships Can Hamper Independence

Directors and management often operate in overlapping social and business networks, and care must be taken to understand the scope, depth, and duration of the personal and business relationships between directors and management, to ensure that the independence of directors is not compromised.

Key Takeaways: Typically, a director's social and business relationships with management of a company do not strip the director of the director's independence. However, care must be taken because in some circumstances such relationships can strip the director of his or her independence. The scope, depth, and duration of the personal and business relationships may lead a court to conclude that a director is not independent.

Summary: Directors and management often operate in overlapping social and business networks, which can be beneficial for them and for the companies that they serve. However, care must be taken to understand the scope, depth, and duration of the personal and business relationships between directors and management, to ensure that the independence of directors is not compromised.

In a Delaware Supreme Court decision, the court concluded that an outside director's personal and business relationships with an insider created a reasonable doubt about the outside director's independence when approving a related-party transaction. As a result, the court reversed a lower court's ruling and thus allowed stockholders to proceed with a derivative lawsuit challenging the fairness of the transaction.

The derivative suit challenged transactions between the company and another entity that was owned by the company's chairman and his son, who was the company's president. The company's board consisted of the chairman, the president, and three outside directors. In the suit, the plaintiffs had to show that a majority of the board was incapable of considering whether to bring the lawsuit. Because two of the five directors were insiders, this meant the plaintiffs had to show that at least one of the remaining three directors was not disinterested and independent.

The plaintiffs focused most of their attention on a director that had the following ties to management:

  • He and the chairman were "close friends for more than five decades";
  • He had donated $12,500 to the chairman's failed gubernatorial campaign;
  • Both the outside director and his brother worked as executives of a company in which the chairman was the "largest stockholder" and a non-independent director and with which the company did business; and
  • The director fees paid to the outside director constituted 30% – 40% of his total income.

The court said that allegations challenging a director's independence must be "considered in full context" and that, while each allegation standing alone might have been insufficient, they collectively cast doubt on whether the outside director was independent of the chairman and his son. In reaching this decision, the court focused on (1) "a close friendship of over half a century" between the outside director and the chairman and (2) the fact that the chairman had "substantial influence" over the outside director's (and his brother's) employer, even though the chairman did not have the power to hire and fire the outside director.

So, while mere allegations that directors move in the same business and social circles as management, or that directors and management are close friends, is not enough to negate independence, there are circumstances where the scope, depth, and duration of the personal and business relationships may lead a court to conclude that a director is not independent.

ENFORCEMENT

Fiduciary Duty in Selecting Share Classes and Adhering to Compliance Policies

A recent SEC enforcement action highlights the need for investment advisers to exercise prudence in selecting share classes for their clients. In the action, the SEC found that dual-registered broker-dealers and investment advisers invested advisory clients in mutual fund share classes with 12b-1 fees instead of lower-fee share classes of the same funds that were available without 12b-1 fees, breaching their fiduciary duty to their clients.

Key Takeaways: The following are key considerations for investment advisers:

  • Conflicts of interest must be fully disclosed to clients. The primary place for this disclosure is in Form ADV and in client service agreements. Other account documentation may also be used to provide needed disclosure to clients.
  • Err on the side of over memorializing actions required to be compliant with federal securities law. While the release that adopted the rule regarding compliance programs stated that the rule does not mandate that the policies and procedures memorialize every action that is required to be compliant with federal securities law, we find that increasingly the SEC exam staff is looking for more documentation, not less.
  • Ensure that when the SEC has noted a deficiency in a prior examination that the deficiency has been corrected. Failure to correct deficiencies can be the difference in being referred to enforcement versus not being referred to enforcement.

Summary: The dual-registered broker-dealers and investment advisers invested advisory clients in mutual fund share classes with 12b-1 fees instead of lower-fee share classes of the same funds that were available without 12b-1 fees, breaching their fiduciary duty to their clients. In their capacity as broker-dealers, these firms received 12b-1 fees paid by the funds in which the advisory clients were invested. By investing these non-qualified advisory clients in the higher-fee share classes, the firms received approximately $2 million in 12b-1 fees that they would not have collected from the lower-fee share classes.

The dual-registered firms failed to disclose in their Forms ADV or otherwise that they had a conflict of interest due to a financial incentive to place advisory clients in higher-fee mutual fund share classes. In addition, the firms failed to adopt any compliance policy governing mutual fund share class selection.

The dual-registered firms disclosed in their respective Forms ADV that the firms may receive 12b-1 fees from mutual fund investments in fee-based advisory accounts. However, the firms did not disclose in their Forms ADV, or otherwise, that they had a conflict of interest with respect to selecting mutual fund share classes due to a financial incentive to place advisory clients in higher-fee share classes over lower-fee share classes of the same mutual fund. Neither the firms' client service agreements nor any other account documentation included any such disclosure concerning mutual fund share class selection.

In addition, the dual-registered firms were found to be repeat offenders in failing to adhere to their compliance policies and procedures. Specifically, the firms failed to monitor advisory accounts quarterly for inactivity or "reverse churning" as required under their compliance policies and procedures to ensure that fee-based advisory or "wrap" accounts that charged an inclusive fee for both advisory services and trading costs remained in the best interest of clients that traded infrequently. They failed to do this even though SEC examination staff previously had cited the firms for failing to conduct such monitoring several years earlier.

As a result of the conduct described above, the SEC found that the dual-registered firms:

  • Willfully violated Section 206(2) of the Investment Advisers Act, which prohibits an investment adviser, directly or indirectly, from engaging "in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client."
  • Willfully violated Section 206(4) of the Investment Advisers Act and Rule 206(4)-7 thereunder, which requires a registered investment adviser to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder.
  • Willfully violated Section 207 of the Advisers Act, which makes it "unlawful for any person willfully to make any untrue statement of a material fact in any registration application or report filed with the Commission ... or willfully to omit to state in any such application or report any material fact which is required to be stated therein."

Penalties: The dual-registered firms were required to (1) retain an independent compliance consultant to assist in improving their compliance program, (2) pay a total of $2,049,859 consisting of disgorgement of $1,956,460 and prejudgment interest of $93,399, and (3) pay a civil monetary penalty in the amount of $7.5 million.

Funds Must be Completely Candid About Investment Strategy and Historical Performance

The SEC recently announced that a Manhattan-based investment advisory firm and its Toronto-based hedge fund manager agreed to settle charges that they misled investors about a fund's investment strategy and historical performance.

Key Takeaways: While the investment adviser and the manager appear to have engaged in some egregious behavior, there are some key takeaways for all investment advisers and mutual funds. Failure to adhere to these takeaways may result in investment advisers and funds facing lawsuits, enforcement actions, and significant monetary penalties:

  • Funds' disclosure about their investment strategy must be accurate, and it must be followed.

    In the SEC enforcement action, the investment adviser and the manager claimed that the fund followed a "five categories" strategy focusing on 285 varying metrics within the categories of momentum, growth, value, risk, and estimates. They also stated that no more than 20 percent of the fund's assets could be invested in any single security, and that no more than 5 percent of the fund's assets could be invested in an illiquid security. Deviation from this investment strategy led to poor performance and a further bad decision to misrepresent fund performance.
  • Historical performance must be accurate.

    In the SEC enforcement action, the manager provided investors with documents that reported purported historical results that were significantly higher than the fund's actual results. In order to show these misleadingly positive returns, the manager excluded the disastrous returns he actually achieved, replacing them with the hypothetical returns that his model purportedly would have achieved if he had applied it correctly and consistently during the periods reported.
  • Any conflict of interest transactions or arrangements must be fully reviewed by the board to determine if they are permissible and in the best interests of the funds, and, if permitted, must be fully disclosed.

    In the SEC enforcement action, the manager did not disclose to the investors that a significant investment had been made in return for the promoters agreeing to help the adviser and the manager find clients.

Summary: The investment advisory firm and manager acted as advisers to a private investment company, or fund. They marketed the fund based on promises to follow a scientific stock selection strategy but, in practice, they repeatedly deviated from that strategy. When an early deviation led to heavy losses, the manager marketed the fund based on a misleading mixture of actual and hypothetical returns. When the investment advisory firm and manager later deviated from the strategy again, by investing most of the fund's assets in a single penny stock, the manager failed to disclose the investment to the fund's investors. The manager also failed to disclose that when he made the investment in the penny stock, he had a conflict of interest.

The manager subsequently used unsupported valuations of the penny stock to make the fund appear more successful than it was, thereby inducing additional investments and delaying investor redemption attempts. He also lied to investors about the fund's liquidity when they began requesting redemptions in 2013. Through these deceptions, the manager delayed the discovery of his fraud and prolonged his ability to earn management and performance fees.

Penalties: The firms will reimburse investors $2.877 million in losses. The manager agreed to pay a $75,000 penalty and is barred from the securities industry.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions