Advisers Act Regulatory Series - Eversheds Sutherland · 2018. 9. 13. · Eversheds Sutherland. Advisers Act Regulatory Series. Speakers. Third Quarter Update. Clifford Kirsch. New

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Third Quarter UpdateAdvisers Act Regulatory Series

September 13, 2018Clifford Kirsch, Michael Koffler, Brian Rubin, Issa Hanna, Ben Marzouk, Bria Adams and Sue Lee

Eversheds Sutherland

Advisers Act Regulatory Series

SpeakersThird Quarter Update

Clifford KirschNew York, NY+1 212 389 [email protected]

Michael KofflerNew York, NY+1 212 389 [email protected]

Brian RubinWashington DC+1 202 383 [email protected]

Ben MarzoukWashington DC+1 202 383 [email protected]

Bria AdamsWashington DC+1 202 383 [email protected]

Sue LeeNew York, NY+1 212 389 [email protected]

Issa HannaNew York, NY+1 212 389 [email protected]


Today’s Discussion:


─ Best Execution Risk Alert

─ Update on Trading Away Enforcement

─ SEC Standard of Conduct Rulemaking Update

─ Testimonial and Pay-to-Play Enforcement Cases

─ Share Class Self-Reporting Initiative Update

─ Other Recent Enforcement Cases

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OCIE Risk Alert: Compliance Issues Related to Best Execution


─ Most frequent best execution issues cited in adviser exams• Not performing best execution reviews• Not considering relevant factors during best execution reviews• Not seeking comparisons from other broker-dealers• Disclosure issues• Soft dollar issues• Weak policies and procedures

─ The Risk Alert reflects issues identified in deficiency letters from more than 1,500 adviser examinations

─ Advisers may wish to amend their disclosures regarding best execution or soft dollar arrangements, revise their compliance policies and procedures, or otherwise change their practices regarding best execution or soft dollar arrangements

─ Advisers may also wish to assess their supervisory, compliance and/or other risk management systems and make changes to strengthen such systems

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─ Not performing best execution reviews• Advisers must be able to demonstrate that they periodically and

systematically evaluate the performance of broker-dealers used to execute trades

─ Not considering materially relevant factors during best execution reviews• Advisers must evaluate any qualitative factors relating to a broker-dealer,

including but not limited to the broker-dealer’s: (i) execution capability; (ii) financial responsibility; and (iii) responsiveness

• Advisers must solicit and review input from traders and portfolio managers

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─ Not seeking comparisons from other broker-dealers• Advisers must seek comparisons from competing broker-dealers initially

and/or on an ongoing basis to assess their chosen broker-dealer’s execution performance

• Advisers must not rely solely on cursory reviews of broker-dealer policies and practices when seeking comparisons

• Advisers must not rely solely on a broker-dealer’s brief summary of its services without seeking comparisons

─ Not fully disclosing best execution practices• Advisers must fully disclose best execution practices• Advisers must disclose, if applicable, that certain types of client accounts

trade after other client accounts and the potential impact of this practice on execution prices

• Best execution practices must align with disclosures in brochures

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─ Not disclosing soft dollar arrangements• Advisers must adequately disclose soft dollar arrangements• Advisers must disclose, if applicable, that certain clients may bear more

of the cost of soft dollar arrangements than other clients• Advisers must provide more detailed disclosure of soft dollar

arrangements when the products or services they receive do not qualify for the Section 28(e) safe harbor

─ Not properly administering mixed use allocations• Advisers must make a reasonable allocation of the cost of a mixed use

product or service according to its use• Advisers must produce support of the rationale for mixed use allocations

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─ Inadequate policies and procedures relating to best execution• Advisers must have policies relating to best execution• Advisers must have sufficient internal controls to monitor execution

performance• Advisers’ policies must take into account the current business of the

advisers

─ Not following best execution policies and procedures• Advisers must follow their policies regarding best execution review• Advisers must allocate soft dollar expenses in accordance with their

policies• Advisers must follow internal policies regarding the ongoing monitoring of

execution price, research and responsiveness of broker-dealers

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Update on Trading Away in Wrap Accounts


─ Recent focus since 2014 • 2014, 2017 and 2018 SEC exam priorities for advisers

• Included best execution and trading away in wrap fee programs

─ Five firms have been sanctioned since July 2016• RiverFront Investment Group (July 14, 2016)• Raymond James & Associates (Sept. 8, 2016)• Robert W. Baird & Co. (Sept. 8, 2016)• Stifel, Nicolaus & Co. (Mar. 13, 2017)• Lockwood Advisors, Inc. (Aug. 14, 2018)

─ We discussed the first four actions in a prior quarterly update – Lockwood case offers new lessons

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─ Typical scenario• Client enrolls in a wrap fee program with an adviser by paying an annual fee

that usually includes advisory services and trade execution through the adviser (or affiliate) at no extra cost

• A portfolio manager could choose the sponsor’s broker to execute a trade• Portfolio manager instead “trades away” to another broker for execution• The client is charged a trade execution fee in addition to the wrap fee

─ The SEC’s main concerns• Is the client being overcharged for trades?• Is the client getting best execution?• What is being disclosed to the client?• Is the program sponsor monitoring its portfolio managers’ trading away

activity?• Are the wrap program and recommended portfolio managers suitable for the

client notwithstanding the extra cost associated with the trading away activity?

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─ A review of the lessons from the first four cases• RiverFront Investment Group

• Update your disclosures as your practices change• Changes to this area are worth a “prompt” update to your Form ADV Brochure• Include the changes in the “material changes” section of the brochure (annual update)

• Raymond James & Associates• Track your sub-advisers’ trading away practices and how much they are costing clients• Be as clear as possible with clients about how much they are paying

• Robert W. Baird & Co.• To help meet fiduciary obligations, consider providing disclosures to clients listing the

percentage of time each sub-adviser traded away and the average cost associated with those trades for the prior calendar year

• Stifel, Nicolaus & Co.• Insufficient to merely disclose that sub-advisers “may” engage in trade aways – must

take the extra step of determining which, how often and costs, and then inform IARs and clients

• To help meet fiduciary obligations, consider adding questions to sub-adviser questionnaires to obtain detailed information about execution policies and trading away practices of sub-advisers

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─ Lockwood Advisors, Inc. (Aug. 14, 2018)• New lessons for wrap fee program sponsors

• Program sponsor should:• As part of the sponsor’s initial screening, before making a portfolio manager available in

its wrap program consider the manager’s history of trading away in other sponsors’ wrap programs, and the likelihood that the portfolio manager would trade away in the program sponsor’s wrap program

• Consider collecting the following information during initial and ongoing diligence of portfolio manager trading away practices:

• Trading away frequency and volume in each available investment strategy measured by total trades, shares or units, and dollar value;

• The cost incurred for each trade away;• The benefits sought and/or realized on behalf of program clients for each trade

away; and• The portfolio manager’s conclusion that best execution was sought and/or achieved,

and the basis for this conclusion in terms of the benefits sought and/or realized and costs incurred

• Consider providing the above information collected during initial and ongoing diligence of portfolio manager trading away practices to program clients, any third-party investment advisers responsible for ensuring the suitability of the wrap program, and the specific portfolio managers for such clients

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SEC Standard of Conduct Rulemaking Update – Background


─ On April 18, in a 4-1 vote, the SEC proposed a comprehensive set of reforms governing the duties and standards of conduct applicable to broker-dealers and investment advisers who provide retail investment advice. The proposed rules would: • Require broker-dealers and investment advisers to summarize their relationship to

retail investors; • Establish a broker-dealer best interest standard of conduct; • Restrict the use of the term “adviser” or “advisor” by broker-dealers; and • Require investment advisers to adhere to certain conduct as fiduciaries

─ The reform package is comprised of three parts:• A Broker-Dealer Standard of Conduct (Regulation Best Interest);• New Disclosures and Titling Requirements for Broker-Dealers, Advisers and Dual

Registrants (the Form CRS Relationship Disclosure); and • Proposed Commission Interpretation Regarding Standard of Conduct for Investment

Advisers and a Request for Comment on Enhancing Investment Adviser Regulation

─ 90-day comment period closed on August 7, 2018

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SEC Standard of Conduct Rulemaking Update – Public Comments


─ Three major buckets:

• (1) Consumer Groups• Consumer Federation of America• AARP• Better Markets

• (2) Broker-Dealers• Securities Industry and Financial Markets Association (SIFMA)• Financial Services Institute (FSI)

• (3) Investment Advisers• Investment Advisers Association

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─ Consumer• “Not far enough”

• Regulation BI disclosures should be strengthened and parallel IA fiduciary duty, otherwise it will lead to investor confusion

• Suitability-plus not an effective means of protecting investors• Form CRS focuses on correct topics, but should provide more clear and straightforward

information• Over reliance on disclosure

• Unlikely to be read• Disclosures will be ineffective due to timing, “reasonable” requirement (not full/fair disclosure),

and the broad discretion afforded to firms• SEC should complement disclosures with more specific requirements, guidance, and

enforcement mechanisms• SEC must clarify and expand investor private remedies for violations of any final rule

(e.g., prohibiting waivers of class actions)• Misguided cost/benefit economic analysis fails to acknowledge the investor harm

caused by confusing standards of care and unchecked conflicts• Overall legal approach questionable – Regulation BI not compatible with Advisers Act,

disregarding will of Congress, First Amendment issues with Form CRS

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─ Broker-Dealers • “Too far”

• General support for SEC rulemaking efforts• But Regulation BI needs more clarity – refined definition of “material conflicts of interest,” more

specific examples of mitigation (or elimination) methods, narrowed recordkeeping obligations• More flexibility regarding use of names/titles• Form CRS disclosures unnecessary, overload investors

• SEC should explicitly affirm that any standards imposed by its rulemaking would preempt any state law requirement

• Harmonize definition of “retail customer” and “retail investor”• Also harmonize with FINRA suitability requirements, which impose a lower standard for

certain institutional investors• Institutional investors should not be required to receive Form CRS

• Duplicative disclosure obligations under Regulation BI and Form CRS• Preserve investor access to diverse business models, including brokerage

and advisory compensation models

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─ Investment Adviser Perspective• Regulation BI:

• General support for extending fiduciary “principles” to all financial services professionals• Potential gap between Regulation BI and IA fiduciary standard for advisory activities performed

by broker-dealers• SEC should better define advice that is not “solely incidental” to brokerage activities for

purposes of the broker-dealer exclusion• Form CRS:

• May not be very effective, and may exacerbate investor confusion regarding their particular relationship with financial professionals

• Educational comparison between BDs and IAs should not be required on form, but rather made available through website

• Should better leverage disclosures already provided in Form ADV• Title prohibitions should also cover deceptive marketing practices

• Fiduciary Duty Interpretation• Not necessary for SEC to issue this interpretation• General support for principles affirmed in the interpretation, but too retail focused• IA fiduciary standard should not be codified in SEC rule

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SEC Standard of Conduct Rulemaking Update – What’s Next?


─ Confirmation of New SEC Commissioners

─ SEC Investor Roundtables

─ SEC instructional video to replace Form CRS disclosures?

─ Timing of final rule

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Testimonial Rule Enforcement Actions – Background


─ Rule 206(4)-1(a)(1) prohibits advisers from publishing, circulating or distributing advertisements that refer, directly or indirectly, to any testimonial concerning the adviser or concerning any advice, analysis, report or other service rendered by the adviser

─ The term “testimonial” is not defined in Rule 206(4)-1, but the SEC staff has consistently interpreted that term to include any statement of a client’s experience with, or endorsement of, an investment adviser

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Testimonial Rule Enforcement Actions


─ On July 10, 2018, the SEC entered into five settlements involving the improper use of testimonials on social media• In re: William M. Greenfield• In re: Brian S. Eyster• In re: Leonard S. Schwartz• In re: HBA Advisors, LLC, and Jaime Enrique Biel• In re: Romano Brothers & Company

─ Three of the settlements involved an investment adviser or an IAR hiring a marketing consultant to contact its advisory clients and solicit testimonials for publication on its websites and social media

─ One settlement was against the marketing consultant for causing the adviser’s violation

─ One settlement involved an adviser that solicited testimonials and posted them on its website and on YouTube

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Testimonial Rule Enforcement Actions – Takeaways


─ The SEC is applying the Staff’s 2014 Guidance Update on the Testimonial Rule in the enforcement context• “When an investment adviser has no ability to affect which public commentary is included

or how the public commentary is presented on an independent social media site; where the commentators’ ability to include the public commentary is not restricted; and where the independent social media site allows for the viewing of all public commentary and updating of new commentary on a real-time basis, the concerns underlying the testimonial prohibition may not be implicated.” See IM Guidance Update No. 2014-04 (Mar. 2014)

• The Guidance Update makes clear that not all testimonials posted to social media regarding an adviser or its personnel are impermissible – i.e., a passive approach is permissible

• However, a common thread in the recent enforcement actions is that the testimonials were not independent of influence by the adviser or its personnel – they actively solicited them and published them on websites they controlled

─ Policies and procedures relating to social media use should make clear that adviser personnel are prohibited from soliciting or influencing testimonials or other commentary about the adviser or personnel on social media pages

─ Given that the violative activity in these actions was coordinated over email correspondence, surveillance search terms should be adjusted as appropriate to flag this conduct

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Pay-to-Play Rule Enforcement Actions – Background


─ Rule 206(4)-5 • A two-year prohibition on an adviser providing compensated services to a

government entity following a political contribution to certain officials of that entity;

• A prohibition on the use of third-party solicitors who are not themselves “regulated persons” subject to pay-to-play restrictions on political contributions; and

• A prohibition on “bundling” and other efforts by advisers to solicit political contributions to certain officials of a government entity to which the adviser is seeking to provide services

─ Applies to all advisers that are registered (or required to be registered) with the SEC, as well as foreign private advisers and exempt reporting advisers

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Pay-to-Play Enforcement Actions


─ On July 10, 2018, the SEC entered into settlements with two registered investment advisers and one exempt reporting adviser• EnCap Investments, LP• Sofinnova Ventures, Inc. • Oaktree Capital Management, LP

─ Covered associates of each of these advisers made campaign contributions to government officials that triggered the two-year time-out from receiving compensation from the public entities and pension plans the officials oversaw

─ However, each of these advisers continued to receive advisory fees attributable to the investments of such public entities and pension plans in covered investment pools

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Pay-to-Play Enforcement Actions – Takeaways


─ Advisers, including exempt reporting advisers, should consider whether their compliance policies and procedures include monitoring and testing functions that are reasonably designed to detect and prevent violations of the rule

─ Exempt reporting advisers should ensure they are aware of their compliance obligations, and have policies and procedures in place to avoid inadvertent violations

─ Advisers and exempt reporting advisers should consider implementing a political contribution pre-clearance system by which covered persons are required to pre-clear certain contributions

─ Ensure covered persons are aware of any pre-clearance policies through mechanisms such as notifications, training and certifications of compliance

─ Consider steps to ensure that relevant employees and senior executives are properly covered by the policies

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Share Class Self-Reporting Initiative Update


─ Prior enforcement actions

─ Share class self-reporting initiative • Where are we?• Issues that have been developing• Where are we going?

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Other Enforcement Cases


─ Three other cases of note• Merrill Lynch (Aug. 20, 2018)• Massachusetts Financial Services Company (Aug. 31, 2018)• Multiple Transamerica Entities (Aug. 27, 2018)

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Questions?

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eversheds-sutherland.com© 2018 Eversheds Sutherland (US) LLPAll rights reserved.

Clifford KirschNew York, NY+1 212 389 [email protected]

Michael KofflerNew York, NY+1 212 389 [email protected]

Brian RubinWashington DC+1 202 383 [email protected]

Ben MarzoukWashington DC+1 202 383 [email protected]

Bria AdamsWashington DC+1 202 383 [email protected]

Sue LeeNew York, NY+1 212 389 [email protected]

Issa HannaNew York, NY+1 212 389 [email protected]

Documents

Advisers Act Regulatory Series - Eversheds Sutherland · 2018. 9. 13. · Eversheds Sutherland. Advisers Act Regulatory Series. Speakers. Third Quarter Update. Clifford Kirsch. New