At the SEC’s 2018 compliance seminar, staff from several of the Commission’s divisions, as well as industry representatives, discussed issues impacting compliance professionals in particular and members of the investment advisory profession in general. Topics addressed included fees and expenses; custody issues; business continuity plans; and ICOs and cryptocurrencies.
Fees and expenses. Adam Aderton, assistant director in the Division of Enforcement’s Asset Management Unit (AMU), outlined several issues identified by AMU relating to the fees and expenses charged by investment advisers. He advised that Enforcement staff will take into account the duration and the magnitude of problematic fees, stating that if a manager is making a lot of money over a long period of time, it will increase the chances of an enforcement action being filed. If a particular undisclosed fee was lucrative and a client was charged for a long time, it will receive Enforcement attention, Aderton warned.
Enforcement will also be more likely to take action in circumstances where clients were charged advisory fees for services that were no longer being performed; for example, where an adviser said they were doing due diligence but ceased doing so and still charged a fee, or charged fees for "orphan accounts" where an individual assigned to an account had left the firm without a replacement to oversee that account, Aderton explained.
Other areas receiving attention from the Enforcement Division include incidents where fees were calculated in a manner contrary to what was disclosed, undisclosed conflicts such as a client being charged fees that were supposed to be borne by the adviser, and share class selection disclosure failures, Aderton explained. Under the Commission’s Share Class Selection Disclosure Initiative, the Division will not recommend civil penalties against advisers who self-report violations of the federal securities laws relating to certain mutual fund share class selection issues and promptly return money to harmed clients; specifically, where an adviser failed to make required disclosures relating to its selection of mutual fund share classes that paid the adviser a 12b-1 fee when a lower-cost share class for the same fund was available to clients. Aderton said the goal of the initiative is to get money back to advisory clients as quickly as possible.
Louis Gracia, deputy associate regional director in the Chicago office for the National Exam Program, highlighted several business practices regarding fees that might catch the eye of examination staff. One such practice is a decentralized billing process where multiple branch units are allowed to conduct their own billing. Exam staff will also take a closer look at manual billing processes such as simple pen and paper records or a spreadsheet that is delinked from disclosures, Gracia advised. Firms should also be aware that staff will take a hard look at poor client record management and a lack of review or oversight of fee billing.
Jennifer Porter, a branch chief in the Division of Investment Management, advised that firms make sure that their disclosures are up-to-date. In particular, she cited the summary of material changes in Form ADV. She noted that although the instructions require the firm to identify and discuss the material changes, in many Forms ADV reviewed by the staff, there was no discussion, just a list of changes. She also said that although the staff does not have the facts and circumstances that are available to the firm to determine if a particular change is material, it still found different things disclosed in Form ADV compared to previous years, which brings up questions of materiality.
Custody issues. Regarding custody issues, Ryan Hinson, regulatory counsel in the SEC’s National Exam Program, identified some recurring themes encountered by examination staff. One theme is the failure to recognize that an adviser does have custody over client access, such as power of attorney, check-writing authority, and password access. Another theme is "surprise" examinations by accountants that are not actually "surprise" at all because the firm was notified in advance. Examiners are also seeing late audits of firm custody practices and the failure to update Form ADV to indicate that an audit has been completed, Hinson said.
Business continuity plans. David Bartels, senior special counsel to the director of Investment Management, noted that the Commission had proposed a rule in 2016 explicitly requiring investment advisers to adopt a business continuity plan in the event of a business disruption such as a natural disaster, cyberattack, or similar event. However, given the Commission’s limited resources, that rule is not currently on the Commission’s regulatory flexibility agenda, Bartels explained. He did note, however, that the proposing release did recognize that many advisers were taking steps to establish business continuity plans. Bartels also observed that the Commission issued relief for the filing and delivery of disclosure documents during last summer’s hurricanes.
Offering an industry perspective, Marshall Sprung, managing director and head of global compliance at Blackstone, said he considers business continuity a business issue rather than a compliance issue. Businesses should be very concerned about their ability to conduct operations in the event of a terrorist attack or cyberattack, he warned. He said that businesses have gained experience through testing, both in real world events such as Hurricane Sandy in New York where employees had remote access, as well as the use of "tabletop" exercises to simulate incidents.
Crypto and ICOs. Regarding initial coin offerings and cryptocurrency issues, Assistant Enforcement Director Corey Schuster said that any uncertainty that ICOs can be securities under the federal securities laws should be put to rest after the Commission’s DAO Report, which cautioned market participants that the offer and sale of digital assets by "virtual" organizations are subject to the requirements of the federal securities laws where they fulfill the elements of an investment contract under the Howey test.
Schuster also noted that the Commission's concerns regarding ICOs and cryptocurrency are not limited to offering fraud, pointing to the Munchee case that involved an unregistered offering of digital tokens without a registration exemption.
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