United States: A Compilation Of Non-Enforcement And Enforcement Actions - 02 June 2016


Mutual Fund Directors Must Be Vigilant in Addressing Risks

In remarks to the Mutual Fund Directors Forum, SEC Chair Mary Jo White outlined some of the risks and challenges that mutual fund directors face, and she shared her view of the role of directors in assessing risks. Ms. White acknowledged the challenge of determining the appropriate dividing line between a director's oversight responsibility and day-to-day management. She also advised that the SEC is focused on that issue as it considers proposed reforms to address the increasingly complex portfolios and operations of mutual funds and exchange-traded funds. She indicated that the staff will carefully consider these matters as it prepares rule recommendations for the SEC's consideration.

Key Takeaways

The following are key considerations for mutual fund directors:

  • Directors must be vigilant in addressing potential risks and plan ahead, rather than react once an event has occurred
  • Directors should ask management how the fund's compliance policies and procedures, business continuity plans, and back-up systems will work in volatile situations
  • Directors should ask questions to ensure that they understand whether the fund's investments are properly aligned with its liquidity needs and redemption obligations
  • Directors should assess the back-up systems and redundancies of service providers to the fund that value the fund and keep track of its holdings and transactions, and consider potential alternative systems in case of a business disruption
  • Directors must ensure that fund payments to financial intermediaries that are used to finance distributions are paid pursuant to a Rule 12b-1 plan

SEC Provides Relief From Custody Requirements for Sub-Advisers

The SEC staff issued a no-action position to the Investment Adviser Association, offering relief from custody requirements as they apply to sub-advisers.

Key Takeaways

Rule 206(4)-2 under the Investment Advisers Act sets forth a number of requirements for investment advisers, including sub-advisers, in possession of client investments. These requirements include obtaining a surprise examination by an independent public accountant to verify the client funds or securities. The SEC said that it 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 an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB)
  • The sub-adviser does not hold client funds itself, have authority to obtain the funds, or have authority to deduct fees from client accounts
  • The sub-adviser continues to obtain from the primary adviser or qualified custodian an annual written internal control report


A registered investment adviser with custody of client funds or securities is required by Rule 206(4)-2 of the Investment Advisers Act to take a number of steps designed to safeguard those client assets. One such step is that an adviser that has custody of client assets generally must undergo an annual surprise examination by an independent public accountant to verify the client funds and securities.

In addition, the SEC recognizes that affiliated custodial relationships present higher risks to advisory clients than where client funds or securities are maintained with an independent custodian. In this regard, where an investment adviser, or its related person, maintains client funds or securities, it must obtain or receive a written internal control report from an independent public accountant that demonstrates that it, or its related person, has established appropriate custodial controls.

Notwithstanding these concerns, staff of the Division of Investment Management said that it would not recommend enforcement action to the SEC under Section 206(4) of, and Rule 206(4)-2 under, the Investment Advisers Act. This includes a situation in which an investment adviser does not obtain a surprise examination, where it acts as a sub-adviser in an investment advisory program for which a related person qualified custodian is the primary adviser (or an affiliate of the primary adviser), and the primary adviser is responsible for complying with Rule 206(4)-2.

This position is based, in particular, on the following:

  1. The sole basis for the sub-adviser having custody is its affiliation with the qualified custodian and the primary adviser
  2. The primary adviser will comply with Rule 206(4)-2, including having client funds and securities in the investment advisory program verified by a surprise examination conducted by an independent public accountant registered with the PCAOB, pursuant to an agreement entered into by the primary adviser
  3. The sub-adviser does not (i) hold client funds or securities itself; (ii) have authority to obtain possession of clients' funds or securities; or (iii) have authority to deduct fees from clients' accounts
  4. The sub-adviser will continue to be required to obtain from the primary adviser, or qualified custodian, an annual written internal control report prepared by an independent public accountant registered with, and subject to, regular inspection by the PCAOB as required by Rule 206(4)-2(a)(6)


SEC Continues Focus on Conflicts of Interest and Adviser Fiduciary Duties

A federal district court granted summary judgment in favor of the SEC in an action against an investment adviser that engaged in a long-term fraudulent scheme to collect bogus research expenses and higher fees from two private funds managed by the adviser.

Key Takeaways

Most of what investment advisers do falls under the general anti-fraud prohibitions in Sections 206(1) and (2) of the Investment Advisers Act and the general fiduciary duties that are enforced through those prohibitions. The courts and the SEC have read these provisions to require advisers: to avoid all conflicts of interest, or at least to fully disclose conflicts to clients; and to put clients' interests ahead of the interests of advisers and their personnel; and these fiduciary obligations are currently subject to rigorous enforcement.


The managing member and CEO of the investment adviser to two private funds, and an employee of the adviser who served as the chief operating officer, engaged in a scheme to defraud the funds of illegitimately claimed research expenses. They misrepresented the employee as an independent research consultant so that the employee could be paid with investor money rather than by the adviser, as was required by the funds' governing documents.

When the soft-dollar balance fell too low to pay the employee's fake research invoices, the employee personally churned the stocks in the private funds' accounts for the sole purpose of generating soft dollars. The excessive trading led to a 600 percent increase in trade commissions charged to the funds, causing further losses for fund investors.

The private funds managed by the investment adviser were authorized to pay the adviser in only two manners: They paid the adviser a monthly management fee of 0.125 percent of the monthly balance of each investor's capital account in the funds, and an annual performance fee of 20 percent of the funds' investment gains. The funds' governing documents did not allow the adviser's officers or employees to draw a salary from the funds.

The CEO and the employee, on behalf of the investment adviser, opened soft-dollar brokerage accounts in the private funds' names. Soft dollars were derived from brokerage trade commissions charged to the funds on each trade placed by the CEO or the employee in the funds' accounts.

The investment adviser was not permitted to draw on the soft-dollar balance, because to do so would have created a conflict of interest in which the adviser could potentially receive soft dollars generated by its clients' trade commissions. Soft dollars could only be paid upon the adviser's authorization to third parties, who provided research-related services that assisted the adviser in its investment-making decisions.

The employee issued monthly invoices for his work at the investment adviser and received regular monthly payments for his work. During one period, the monthly salary payments totaled $549,284.97; $449,784.97 of this amount consisted of "soft dollars," and the remaining $99,500 of salary payments came directly from the adviser. The adviser was, in turn, reimbursed by the private funds for these monthly payments to the employee.

The private funds' governing documents provided that the investment adviser could spend "soft dollars" on research products or services provided to the adviser by others. The governing documents did not allow the adviser to use soft dollars to pay for anything other than research products or services. They did not allow the adviser to use the soft dollars to pay the salaries of the adviser's officers or employees.

The employee created monthly invoices for his work at the investment adviser. Each invoice amount usually matched the amount of the salary payment the employee received each month. The invoices merely stated that the employee's services consisted of research provided for the adviser.

The CEO told the party that paid the soft dollars that the employee was an independent research consultant.


The SEC charged the investment adviser and the individual defendants with 16 counts of violating the antifraud provisions of the federal securities laws and certain reporting provisions. The court concluded that permanent injunctions against the adviser and its CEO were appropriate given the repeated exploitation of investors. The court also ordered joint and several disgorgement of ill-gotten gains of just over $630,000, plus prejudgment interest, and a $100,000 civil penalty.

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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