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OMG! SEC Gives Tips on IM and Texting, More Advisers Caught in 12b-1 Fee Scandal, and Lessons Learned from FINRA Exams: Regulatory Update for January 2019

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For Investment Advisers: SEC Actions

SEC Risk Alert – Observations from Investment Adviser Examinations Relating to Electronic Messaging:  In 2017, the OCIE performed a sweep exam targeting the use of electronic communications by investment advisers.  OCIE focused on the newer alternative methods of electronic messaging (including instant messaging apps, personal email and texting), rather than email traffic.

As stated in the release, the use of mobile and personally-owned devices “pose challenges for advisers in meeting their obligations under the Books and Records Rule (Rule 204-2) and the Compliance Rule (Rule 206(4)-7). “  In the alert, OCIE recommends that advisers take these steps:

  • Adopt policies and procedures that
    1. require employees to use messaging systems that are retained on the firm’s books and records,
    2. require employees to switch to an approved messaging system when they receive communication through an unapproved channel,
    3. address the monitoring, review, and retention of required records on electronic messaging systems, and
    4. reinforce that violations of a firm’s procedures may result in discipline or dismissal;
  • Institute employee training and compliance attestations starting at the time of hire and regularly occurring throughout employment;
  • Supervise electronic communications, including hiring vendors to monitor employees’ electronic messaging (such as a service that archives a firm’s and its employee’s LinkedIn and Facebook pages) and regularly review employee social media and web activity; and
  • Use device control mechanisms such as a pre-approval requirement to access the firm’s systems from a personal device, installation of security applications on personal devices to facilitate installing patches and remote “wiping” if a device is stolen or lost, and the use of technology (such as VPN) that blocks an employee’s remote access to the firm’s server.

Firms can leverage this framework to evaluate and respond to new messaging technologies.  Contributed by Cari Hopfensperger, Senior Compliance Consultant.

SEC Continues to Pound Advisers for Inadequate Disclosures on 12b-1 Fees and Revenue Sharing.  The SEC’s Enforcement Division is sending out document requests to dually-registered investment advisers and investment advisers with broker-dealer affiliates that did not self-report during the Share Class Disclosure Initiative.  (See our blog post for more details.) The SEC published two more settlements against investment advisers for selecting mutual fund share classes inconsistent with disclosures to clients.  See American Portfolio Advisers, Inc. and PPS Advisors, Inc., and PassarettiContributed by Jaqueline M. Hummel, Partner and Managing Director.

For Broker-Dealers:  FINRA Actions 

FINRA Releases Its Second Annual Report on Examination Findings:  The 2018 Report on FINRA Examination Findings (“Report”) is now available as a resource for firms looking to enhance their compliance programs in 2019.  The Report identifies common examination deficiencies and highlights policies and procedures that have helped firms comply with certain rules and regulations.  The Report focuses on suitability for retail customers, fixed income mark-up disclosure, due diligence for private placements, and abuse of authority.  We encourage you to read the Report along with FINRA’s Regulatory and Examination Priorities Letter for 2019 to identify and correct potential weaknesses in your existing compliance program before the regulators arrive.  These are great tools for identifying and managing compliance risk.  Contributed by Rochelle Truzzi, Senior Compliance Consultant.

Lessons Learned from Recent SEC and FINRA Cases

The SEC Embraces the Holiday Spirit and Shows Compassion Regarding Fee Violations.  In the case of Retirement Capital Strategies (“RCS”), the SEC showed some mercy by only doling out a $50,000 fine when it learned that the firm had overcharged separately managed account clients from 2010 to 2018.  RCS used a breakpoint fee schedule which incentivized clients to increase their assets with the firm to receive a reduced fee. The fee schedule was disclosed in the Form ADV Part 2, “Exhibit A” to the investment advisory agreement and included in the firm’s policies and procedures. “Although RCS told clients it would enclose the Fee Schedule as “Exhibit A” to the investment advisory agreement, it did not enclose the Fee Schedule.”  Fees were charged quarterly in advance based on the assets under management on the last business day of the month. Householding client accounts was permitted to reduce the overall fee charged.

Despite this disclosure, RCS did not always aggregate client assets so that clients could receive the reduced fee, and overcharged 293 clients in the amount of $304,000.  The issue was discovered during an SEC investigation.  At that time, the firm voluntarily refunded, with interest, all overcharged advisory fees.  RCS updated its policies and procedures to address its billing issues and hired a compliance consultant to review its policies and procedures and Form ADV disclosures.   Ultimately, RCS was found to have willfully violated Section 206 (2), 206 (4) and 207 of the Investment Advisers Act and was fined $50,000. The big takeaway from this case is that it’s critical for compliance staff to conduct testing to verify fee calculations, policies and procedures and disclosures. At a minimum, fee testing should include:

  • Determining a sample of accounts and a specific billing period to be reviewed
  • Comparing each client’s investment advisory agreement and fee schedule against the billing system
  • Recalculating the fee
  • Reviewing the client’s custodial statement to verify the AUM of the account(s) used in the fee calculation
  • Verifying the amount of the fee deducted from the custodial account or directly paid by the client
  • Documenting the testing results and, if irregularities are identified, addressing them immediately
  • Reviewing the Form ADV disclosure and policies and procedures to insure accuracy, and
  • Potentially raising or lowering risk levels on the Annual Risk Assessment based on the results of testing and complexity of the fee billing schedule and process

Contributed by Heather Augustine, Senior Compliance Consultant. 

BDC Adviser Pays $3.8 Million for Expense Misallocation, Valuation Missteps, and Improper Handling of MNPI.   This case and other recent enforcement actions against business development companies (“BDCs”) may signal a trend of increasing SEC interest.  Private equity advisers should also pay close attention to the SEC’s findings.

Fifth Street Management, LLC (“FSM”) provided investment advisory services to two BDC clients, and some other private investment companies.   Consistent with its actions against private fund advisers, the SEC charged the firm with the improper allocation of expenses to the BDCs and valuation errors leading to a material misstatement on public SEC filings.  In an interesting twist, the SEC also found that the firm failed to prevent the misuse of material, non-public information from the BDC portfolio companies by firm employees managing other portfolios.

IMPROPER EXPENSE ALLOCATION – Contrary to the firm’s investment agreement with its two BDC fund clients (and its Form ADV), FSM  improperly allocated $1,327,405 in rent, other overhead and compensation expenses to the BDCs.  In its order, the SEC noted the FSM’s failure to establish related policies and procedures.  Advisers should document and review expense allocation practices periodically, and that such practices are consistent with language in Form ADV, investment management agreements, and private fund documents.  See also SEC Risk Alert on Fees and Expenses.

VALUATION ERRORS – The SEC found that failures in the adviser’s valuation quality control (QC) process led to overstated values for two of the funds’ illiquid investments.  These incorrect values led to fee calculation errors and ultimately to the BDCs materially misstating data in their 10K and 10Q filings.  Exacerbating the issue, the BDC sold additional shares and conducted a secondary offering when its value was overstated.  Although there was a valuation process in place, the employees responsible for inputting the data failed to detect inaccurate inputs or question the results of the model.  The errors carried forward over three quarterly valuation cycles.

These findings reinforce that the valuation process is critical to an adviser’s operations.  A pricing error can have far-reaching implications on portfolio valuations, leading to mistakes in fee and performance calculations, client reporting and potentially on rebalancing or trading decisions.  Additionally, a well-defined process is instrumental, but process and checklists are just tools within the framework – they are not effective if employees don’t thoroughly understand their roles and responsibilities.  Similarly, firm management should ensure that employees performing testing are sufficiently experienced and trained.  Finally, firms should review procedures with an eye to identifying data dependencies and hand offs as points of risk where things can, and often do, go wrong.  Additional checks and balances can often mitigate these risks. Written procedures and training should have helped avoid these errors; but by taking additional measures, such as rotating the analysts periodically, or adding a senior team member for a higher level ‘sniff-test’ of reasonability before final approval, advisers may catch unnoticed errors sooner.

MATERIAL NON-PUBLIC INFORMATION – The SEC found that FSM’s policies and procedures were not robust enough to prevent the adviser’s misuse of material non-public information (MNPI) for the benefit of its hedge fund clients.  Apparently, there was no “fire wall” between the employees receiving confidential information about the BDC’s portfolio companies and those employees making investment decisions for FSM’s hedge funds.  Firms that receive MNPI should consider whether their policies and procedures are sufficient to limit access to that information to only those supervised persons with a “need to know.”

Ultimately, FSM has to pay disgorgement, prejudgment interest and civil money penalties totaling just under $4 million.  FSM sold its assets to another firm and withdrew its SEC registration in November 2017.  Contributed by Cari Hopfensperger, Senior Compliance Consultant. 

 Worth Reading  

Explaining Bitcoin with Pokemon cards – Jack Dossman explains the basics of blockchain and distributed ledger technology (or even Pokeman cards).

SEC Looks Deeper at Advisors’ Share Class Use, Revenue Sharing:  Melanie Waddell discusses the SEC’s recent investigations into firms that did not self-report violations under the Share Class Disclosure Initiative.

Hedge Funds Nuts & Bolts: Brexit for Hedge Fund Managers – Four Months and Counting – Dechert LLP provides this informational webinar for advisers with business activities involving the UK.

50-State Survey on Senior and Vulnerable Investor Laws:  Bressler, Amery & Ross provide this excellent resource for RIAs and BDs.

Five Challenges Facing Advisors in 2019:  Bob Veres provides his predictions for advisers in 2019.

CCOs need to fill in compliance grey areas with paperwork:  Dominic Diogson discusses the Thaddeus North case on CCO liability, with some help from Sam Waldon, attorney at ProskauerRose LLP.

Five Areas in which Marriott Data Breach Raises Red Flags for Financial Firms: Richard Satran highlights five potential pain points for banks and other financial service firms, using Marriott International’s data breach as a chilling example.

Filing Deadlines and To Do List for January 2019


  • Form 13H: Amendment to Form 13H due promptly if there are any changes to information for Form 13H Filers.  The SEC’s “Frequently Asked Questions Concerning Large Trader Reporting,” response 2.5 says Form 13H Filers may file an amendment and an annual amendment together if any changes occurred during the fourth quarter to the information contained in Form 13H. An amendment is due “promptly,” which we interpret as within ten days.  Recommended due date:  January 10, 2019.  (Note:  Neither the SEC nor its staff has provided guidance on the definition of “promptly” for Form 13H.)  Due date:  January 10, 2019.


  • Customer Complaint Quarterly Statistical Summary: For complaints received during the 4th Quarter, 2018.  FINRA Rule 4530 requires Firms to submit statistical and summary information regarding complaints received during the quarter by the 15th day of the month following the calendar quarter.  Due date:  January 15, 2019.
  • Final Renewal Payment:    Full payment of your FINRA 2018 Final Renewal Statement is due. Due date January 21, 2019.
  • FINRA Contact System Annual Review:  FINRA Rule 4517 requires Firms to review and, if necessary, update the required FINRA Contact System information within the first 17 business days of each calendar year.  Due date:  January 25, 2019.
  • MSRB Form A-12 Annual Affirmation.  MSRB Rule A-12(k) requires each broker that is a member of the MSRB to review, update as necessary, and affirm the information in Form A-12 during the Annual Affirmation Period that begins on January 1 of each calendar year and ends 17 business days thereafter. Due date: January 25, 2019.
  • Rule 17a-5 Quarterly FOCUS Part II/IIA Filings:  For Quarter ending December 31st.  SEC requires that member firms file a FOCUS, (Financial and Operational Combined Uniform Single) Report Part II or IIA on a quarterly basis. Clearing firms and firms that carry customer accounts file Part II and introducing firms file Part IIA. Due date:  January 25, 2019. 
  • Annual FOCUS Schedule I Filing for 2018:  SEC requires all broker-dealers to submit operational information as of December 31st via the Annual FOCUS Schedule 1 Filing. Due date:  January 25, 2019.
  • Quarterly Form Custody:  SEC requires that member firms file Form Custody under SEA Rule 17a-5(a)(5) for the quarter ending December 31st. Due date:  January 25, 2019.
  • Annual Audit Reports for Fiscal Year-End November 30, 2018:  SEC requires that member firms submit their annual audit reports in electronic form.  Firms must also file the report at the regional office of the SEC in which the firm has its principal place of business and the SEC’s principal office in Washington, DC. Firms registered in Arizona, Hawaii, Louisiana, or New Hampshire may have additional filing requirements. Due date:  January 29, 2019. 
  • SIPC-7 Assessment: For firms with a Fiscal Year end of November 30, 2018.  SIPC members are required to file the SIPC-7 General Assessment Reconciliation Form together with the assessment owed (less any assessment paid with SIPC-6) within 60 days after the fiscal year-end.  Due date:  January 29, 2019.
  • Supplemental Statement of Income (“SSOI”):  For the quarter ending December 31, 2018.  FINRA requires firms to submit additional, detailed information regarding the categories of revenues and expenses reported on the Statement of Income (Loss) page of the FOCUS Report Part II/IIA.  Due date:  January 30, 2019.
  • Supplemental Inventory Schedule (“SIS”):  For the month ending December 31, 2018. The SIS must be filed by a firm that is required to file FOCUS Report Part II, FOCUS Report Part IIA or FOGS Report Part I, with inventory positions as of the end of the FOCUS or FOGS reporting period, unless the firm has (1) a minimum dollar net capital or liquid capital requirement of less than $100,000; or (2) inventory positions consisting only of money market mutual funds.  A firm with inventory positions consisting only of money market mutual funds must affirmatively indicate through the eFOCUS system that no SIS filing is required for the reporting period. Due date: January 30, 2019.
  • SIPC-3 Certification of Exclusion from Membership:  For firms with a Fiscal Year-End of December 31, 2018 AND claiming an exclusion from SIPC Membership under Section 78ccc(a)(2)(A) of the Securities Investor Protection Act of 1970.  This annual filing is due within 30 days of the beginning of each fiscal year. Due date: January 30, 2019.



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