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Investment Management Legal and Regulatory Update - October 2012

October 04, 2012

SEC Debates on Money Market Reform Continue
SEC Chairman Mary Schapiro issued a statement on August 22, 2012 cancelling a scheduled vote on money market fund reforms after three commissioners, constituting a majority of the Commission, informed her that they did not support the proposed reforms. Chairman Schapiro expressed her view that the structural reform of money markets is one of the pieces of unfinished business from the financial crisis. Ms. Schapiro urged other policymakers to consider ways to address the systemic risk posed by money market funds.

SEC Commissioner Luis Aguilar issued a statement on August 23 asking for a concept release to study the cash management industry as a whole to understand the role, and relative size, of SEC-registered money market funds in that overall industry. He also asked for an analysis of the effects of the SEC's 2010 money market fund amendments.

On August 28, Commissioners Daniel Gallagher and Troy Paredes issued a joint statement that they were "dismayed" by the Chairman's comments and that her statement "creates the misimpression that three commissioners - a majority of the Commission - are not concerned with, or are somehow dismissive of, the goal of strengthening money market funds. This is wholly inaccurate."

On September 14, Senator Bob Corker, a member of the Senate Banking Committee, sent a letter to the Commission stating his concern that "a run on money market funds is still a real risk in the case of financial system dislocation" and encouraging the SEC to move forward with a reform proposal.

According to Bloomberg, Commissioners Aguilar, Gallagher and Paredes sent a letter to Chairman Schapiro and SEC chief economist Craig Lewis on September 17 seeking a study of money market regulations and an analysis of whether certain rules could disrupt money market funds and short-term credit markets.

In a Wall Street Journal opinion on September 21, Chairman Schapiro called for the Financial Stability Oversight Council to tackle money market fund reforms.

Sources: Statement of SEC Chairman Mary L. Schapiro on Money Market Fund Reform, SEC Press Release 2012-166, August 22, 2012; Statement Regarding Money Market Funds, Commissioner Luis A. Aguilar, August 23, 2012; Statement on the Regulation of Money Market Funds, Commissioners Daniel M. Gallagher and Troy A. Paredes, August 28, 2012; Beagan Wilcox Volz, Mud Flies at SEC in Rare Public Display of Acrimony, Ignites, August 30, 2012; Beagan Wilcox Volz, Senator Urges SEC to Move Ahead with Money Fund Reforms, Ignites, September 18, 2012; Joe Morris, SEC Commissioners Press for Money Fund Study, Ignites, September 19, 2012; Money-Market Study,, September 19, 2012; Joe Morris, SEC's Schapiro Invites FSOC Intervention, Ignites, September 21, 2012; In the Money-Market for More Oversight, Wall Street Journal, September 21, 2012.

SEC Proposes Rules to Permit General Solicitation and Advertising
Regulation D currently prohibits the use of general solicitation or general advertising in connection with the sale of interests in hedge funds and other private offerings. The Jumpstart Our Business Startups Act (JOBS Act) directed the SEC to amend Regulation D to eliminate this prohibition. In furtherance of this Congressional mandate, the SEC recently proposed amendments to Rule 506 (new Rule 506(c)) of Regulation D to provide that the prohibition against general solicitation generally will not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that the purchasers are accredited investors. The SEC took the position that proposing specific verification methods that an issuer must use "would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor." Rather, the SEC suggested that an issuer must consider the facts and circumstances, including the nature of the purchaser and the type of accredited investor that the purchaser claims to be; the amount and type of information that the issuer has about the purchaser; and the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering and the terms of the offering, such as the minimum investment amount. The SEC also proposed an amendment to Form D to add a box for issuers to check if they are claiming the new Rule 506 exemption that would permit general solicitation and general advertising. The SEC proposed to preserve current Rule 506 as Rule 506(b) to give issuers the option of raising capital through offerings to non-accredited investors and/or of relying on the "reasonable belief" standard for determining whether a purchaser is an accredited investor.

Source: Eliminating the Prohibition against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Release No. 33-9354, August 29, 2012.

SEC Approves FINRA Rule 5123 Regarding Private Placement of Securities
The SEC approved FINRA Rule 5123, which requires brokers that sell securities in a private placement to file with FINRA a copy of any private placement memorandum, term sheet or other offering document, or indicate that the broker did not use any such offering documents. The rule becomes effective December 3, 2012, and applies prospectively to private placements that begin selling efforts on or after that date. The broker must file a copy of the offering document within 15 calendar days of the date of the first sale, and must file any materially amended versions of the document. The filing will be a "notice" type filing, and FINRA will not respond to the filings with a comment letter or provide a clearance letter. The rule exempts private placements sold solely to qualified purchasers, institutional purchasers and other sophisticated investors.

Source: FINRA Regulatory Notice 12-40, September 2012.

CFTC Releases FAQ regarding CPO and CTA Compliance Obligations
The Commodity Futures Trading Commission (CFTC) adopted amendments that will require advisers to mutual funds that invest more than a limited amount in commodity interests for other than bona fide hedging purposes to register as commodity pool operators (CPOs), effective December 31, 2012. The CFTC also rescinded Rule 4.13(a)(4), which exempted from CPO registration sponsors of private funds offered only to certain highly sophisticated investors. The CFTC maintained the de minimis exemption under Rule 4.13(a)(3), which is available to private funds that are offered only to accredited investors, knowledgeable employees or qualified eligible persons and that are subject to a five percent trading threshold or 100 percent notional value test. See our April 2012 Update for more information about the amendments.

On August 14, 2012, the CFTC released responses to frequently asked questions (FAQs) regarding compliance obligations for CPOs and commodity trading advisers (CTAs). The CFTC clarified that equitization of cash and risk management are not properly included as bona fide hedging transactions. The CFTC confirmed that a private fund would not be in violation of the trading limits of Rule 4.13(a)(3) if it temporarily crosses the de minimis thresholds so long as the fund is in compliance with the trading threshold at the time a position is established. Finally, the CFTC advised that directors and trustees of a mutual fund with an investment adviser that must now register as a CPO are subject to prohibitions under the Commodity Exchange Act that are applicable to all market participants, including the anti-fraud and anti-manipulation provisions.

Source: Commodity Futures Trading Commission, Division of Swap Dealer and Intermediary Oversight Responds to Frequently Asked Questions -- CPO/CTA: Amendments to Compliance Obligations, August 14, 2012.

SEC Delays Compliance Date for Pay to Play Ban on Third-Party Solicitation
The SEC delayed the compliance date for portions of the pay to play rule under the Advisers Act relating to the use of third-party solicitors. In July 2010, the SEC adopted Rule 206(4)-5, the pay to play rule, which prohibits advisers from receiving compensation from state and local government clients for two years after the adviser or certain of its executives or employees make a contribution to certain elected officials or candidates. The two-year timeout provision has been in effect since March 2011. The pay to play rule also prohibits advisers from paying compensation to any third party to solicit advisory business from state or local governments unless the third party is an SEC-registered investment adviser or a registered broker-dealer subject to pay to play restrictions. See our July 2010 Update for more information about the pay to play rule.

The compliance date for the ban on third-party solicitation is extended until nine months after the compliance date of a final rule to be adopted by the SEC requiring municipal advisor firms to register, which is not expected until 2013. See "SEC Extends Temporary Registration of Municipal Advisors" below. Once the final rule is adopted, the SEC will issue the new compliance date for the ban on third-party solicitation.

Source: Political Contributions by Certain Investment Advisers: Ban on Third-Party Solicitation: Extension of Compliance Date, SEC Release No. IA-3418, June 11, 2012.

SEC Extends Temporary Registration of Municipal Advisors
The SEC has extended the sunset date of rules for temporary registration of municipal advisors under interim final temporary Rule 15Ba2-6T under the Securities Exchange Act by one year to September 30, 2013. The interim final temporary rule was to expire September 30, 2012. By extending the sunset date for a second time, the SEC also extends by one year the date by which it must take action on its proposed final rules for registration of municipal advisors.

Source: Extension of Temporary Registration of Municipal Advisors, SEC Release No. 34-67901, September 21, 2012.

SEC Issues Risk Alert on Pay to Play Prohibitions under MSRB Rules
The SEC issued a risk alert on political contributions made by brokers, dealers and municipal securities dealers engaged in the municipal securities business. MSRB Rule G-37 generally prohibits firms from engaging in municipal securities business with an issuer for two years after any contributions to an official of the issuer by the firm, its municipal finance professionals (MFP) or a political action committee controlled by the firm or a MFP. Firms are required to file Form G-37 with the MSRB. The alert notes that SEC examiners have observed practices that raise concerns about some firms' compliance with their obligations under MSRB Rule G-37. Some firms have engaged in municipal securities business with issuers within two years of their MFPs having made political contributions. Other firms have failed to file accurate and complete Forms G-37.

Source: SEC Issues Risk Alert on "Pay-to-Play" Prohibitions under MSRB Rules, SEC Press Release 2012-173, August 31, 2012.

SEC Financial Literacy Study
The SEC issued a staff study (mandated by the Dodd-Frank Act) with findings on what investors want to know about financial professionals and investment products and services, and when and how investors want to receive such information. The study shows that investors prefer to receive investment disclosures before investing, rather than after, as occurs with many investment products purchased today. The study identifies information that investors find useful and relevant, such as information about fees, investment objectives, performance, strategy, and risks of an investment product, as well as the professional background, disciplinary history and conflicts of interest of a financial professional. Investors also favor summary documents and investment disclosures presented in a visual format, using bullets, charts and graphs.

"Understanding the needs of investors is critical to carrying out the Commission's investor protection mission," said SEC Chairman Mary Schapiro. "The study provides important data and insights that will assist the Commission in its ongoing efforts to help retail investors make informed investing decisions."

Sources: SEC Issues Financial Literacy Study Mandated by the Dodd-Frank Act, SEC Press Release 2012-172, August 30, 2012; Study Regarding Financial Literacy Among Investors as Required by Section 917 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, August 2012.


SEC Sends a Wells Notice to Northern Lights Fund Trust

The SEC sent a Wells notice to Northern Lights Fund Trust (NLFT) and certain of its current and former trustees and its chief compliance officer advising them that the SEC staff is considering recommending enforcement proceedings against them for alleged violations of securities laws. According to a SEC filing made by the NLFT, the Wells notice "relates primarily to the process by which certain investment advisory agreements between NLFT (on behalf of a small number of funds in the Trust) and their advisers were approved, and the disclosures regarding the same." In its filing, the NLFT stated that "the Trust disagrees with the SEC's potential allegations and believes its actions complied with existing rules" and stated that it "is cooperating with the SEC staff to seek a resolution to this matter."

Sources: Joe Morris, SEC Hits Northern Lights Trust with Wells Notice, Ignites, June 15, 2012; Northern Lights Fund Trust, Prospectus Supplement dated June 8, 2012.

SEC Sanctions Adviser for Failing to Disclose Revenue-Sharing Payments, 15(c) Violation and Conflict of Interest
The SEC settled an administrative proceeding against two Portland, Oregon-based investment advisers, Focus Point Solutions, Inc. and The H Group, Inc., and their owner, Christopher Keil Hicks, for failure to disclose a revenue-sharing agreement and other potential conflicts of interest. Without admitting or denying the SEC's allegations, Hicks, Focus Point and The H Group agreed to pay a combined $1.1 million in fines.

Revenue Sharing. Focus Point provides non-discretionary investment advice to The H Group and independent advisers. When an adviser hires Focus Point, Focus Point provides that adviser with access to Focus Point's proprietary asset allocation models made up of mutual fund and ETF selections. In 2007, Focus Point and a broker entered into a custodial support services agreement, whereby Focus Point agreed to perform certain custodial support services (such as facilitating asset transfers, updating client information for the broker, handling client inquiries and assisting with client paperwork) in exchange for payment by the broker of a certain percentage of every dollar that Focus Point's clients invested in no transaction fee (NTF) mutual funds. Focus Point did not disclose the existence of the agreement in its Form ADV. The SEC stated that "clients were thus unaware that Focus Point might have a bias in favor of the broker's NTF funds over other investments that would not generate revenue for Focus Point under the revenue-sharing deal with the broker, leading to potentially conflicted investment advice."

15(c) Violation. During the process of being hired as a sub-adviser to the Generations Multi-Strategy Fund, Focus Point told the trustees that Focus Point would not receive any compensation beyond its sub-advisory fee. However, according to the SEC, "unbeknownst to the trustees" Focus Point had an arrangement with the fund's primary adviser that the primary adviser would pay Focus Point an additional 15 basis points on the assets under management in the fund.

Proxy Voting Conflict of Interest. Focus Point's request to be retained as sub-adviser to the fund also required he approval of the fund's shareholders, the vast majority of whom were clients of The H Group. The H Group had a potential conflict of interest as a related entity to Focus Point and an incentive to vote in its and its related adviser's best interests rather than in the best interest of The H Group's clients. Therefore, The H Group's proxy voting policy required the proxies to be voted by the investors themselves. Instead, The H Group itself voted client proxies in favor of the proposal to approve Focus Point as the fund's sub-adviser, despite its related adviser having a financial interest in the outcome of the vote.

Source: In the Matter of Focus Point Solutions, Inc., The H Group, Inc. and Christopher Keil Hicks, SEC Administrative Proceeding File No. 3-15011, September 6, 2012.

SEC Charges Adviser with Failing to Turn Records Over to SEC and 15(c) Violation
The SEC charged David Dube, a Florida-based investment manager, and his firm, Peak Wealth Opportunities LLC, for failing to provide SEC examiners with records of the StockCar Stocks Index Fund, a mutual fund managed by Peak Wealth that invested in NASCAR-related stocks. SEC examination staff requested records from Peak Wealth and Dube in 2010 while examining Peak Wealth's advisory business and the operations of the fund. Despite repeated requests, Dube and Peak Wealth allegedly failed to furnish certain records to the SEC.

The SEC also charged Dube and Peak Wealth with failing to provide the fund's board of directors with information reasonably necessary to assess Peak Wealth's advisory fees. Simultaneously with the SEC's examination in 2010, the fund's board requested information from Peak Wealth and Dube as part of the fund's required annual evaluation of its advisory agreement under Section 15(c) of the Investment Company Act. Section 15(c) makes it the duty of the adviser to furnish such information as may reasonably be necessary for fund directors to evaluate the terms of any advisory agreement. Despite requesting additional time to respond to the board, Peak Wealth and Dube failed to provide any of the requested documents or information necessary for the board to evaluate the nature, quality, and cost of the adviser's services. The board subsequently terminated Peak Wealth's advisory agreement and liquidated the fund by returning the money to investors.

"A fully-informed board is crucial to the advisory fee setting process, yet Dube failed to provide the board with the most basic of information," said Chad Alan Earnst, an Assistant Regional Director in the Enforcement Division's Asset Management Unit.

Sources: SEC Charges Mutual Fund Adviser with Failing to Turn Over Records to SEC Examiners, SEC Press Release 2012-154, August 10, 2012; In The Matter of Peak Wealth Opportunities LLC and David Dube, CPA, SEC Administrative Proceeding File 3-14979, August 10, 2012.

SEC Imposes Sanctions Against Adviser for Failure to Adopt and Implement Written Compliance Procedures and to Remedy Past Deficiencies
The SEC instituted administrative cease and desist proceedings and settled with Consultiva Internacional, Inc., a registered investment adviser based in Puerto Rico. The SEC alleged that from June 2005 through December 2010, Consultiva failed to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules as required by Rule 206(4)-7. The SEC's exam staff conducted an examination of Consultiva in June 2005 and issued a deficiency letter in September 2005 noting several issues. These issues included Consultiva's failure to maintain a compliance manual adequately tailored to its business. The exam staff noted that Consultiva's compliance manual appeared tailored to broker-dealer compliance rather than Consultiva's investment advisory business. The exam staff also questioned the CCO's ability to adequately oversee Consultiva's compliance operations due to his lack of familiarity with the Advisers Act and failure to obtain the proper training. In addition, the exam staff noted several inaccuracies and inconsistencies in the firm's Form ADV as compared to its investment advisory business. In December 2010, when the SEC exam staff returned to Consultiva to conduct another examination, it stated that while Consultiva had undertaken certain corrective steps in response to the 2005 exam findings, it had not taken all of the necessary remedial steps. The SEC alleged that its December 2010 examination also revealed additional problems with Consultiva's compliance program, such as Consultiva did not adequately conduct, or did not sufficiently document, annual reviews of its compliance program. According to the SEC, Consultiva also did not follow all of the policies and procedures established in its code of ethics. For example, Consultiva did not document whether it had obtained from each of its access persons annual reports of their securities holdings. Moreover, on at least one occasion, Consultiva's CCO allegedly reviewed and signed off on his own quarterly report of personal securities transactions. In settling the proceedings, Consultiva neither admitted nor denied the SEC's allegations, but Consultiva agreed to hire an independent compliance consultant to review its compliance policies and procedures and pay a $35,000 fine.

Source: In the Matter of Consultiva Internacional, Inc., SEC Administrative Proceeding File No. 3-14973, August 3, 2012.

SEC Imposes Sanctions Against Adviser for Interest-Free Loans from Hedge Fund
The SEC instituted administrative cease and desist proceedings and settled with Centaur Management, a registered investment adviser. The SEC alleged that Centaur directed its client, Argent Classic Convertible Arbitrage Fund L.P., to provide the adviser with approximately $15 million in interest-free loans during a three-year period. According to the SEC, Centaur used these loans to fund the payroll for employees who provided management and accounting services, not only for Argent Classic, but also for up to fourteen related funds. No interest was paid on the vast majority of the loans from Argent Classic, and thus, Centaur deprived Argent Classic of the use of its capital. As the investment adviser to Argent Classic, Centaur owed a fiduciary duty to its client. The SEC stated that Centaur breached its fiduciary duty by inappropriately using Argent Classic funds to make no-interest loans and as a result, Centaur violated Section 206(2) of the Advisers Act, which prohibits fraudulent conduct by an investment adviser.

The SEC also alleged that Centaur failed to adequately disclose the loan practice to the Argent Classic investors. Argent Classic's limited partnership agreement, subscription agreement, and private offering summary omitted any mention of the loan practice. The loans were described in Argent Classic's audited financial statements as payroll receivables, but were not disclosed as loans directed by Centaur, that they were interest-free, or that they were being used to cover payroll expenses for funds other than Argent Classic.

According to the SEC, Centaur violated Section 206(4) of the Advisers Act and Rule 206(4)-8, which prohibit an investment adviser to a pooled vehicle from making any false or misleading material statements of facts or omitting to state material facts to any investor or prospective investor in a pooled investment vehicle. Without admitting or denying the SEC's allegations, Centaur agreed to a censure and to pay a civil money penalty of $150,000, disgorgement of $172,438 (the amount of interest it should have paid on the loan) and prejudgment interest of $41,884 to the SEC.

Source: In the Matter of Centuar Management Co. LLC, SEC Administrative Proceeding File No.3-14950, July 17, 2012.

SEC Charges Asset Manager Lied to Investors, Hid Major Losses While Boasting Remarkable Performance During Financial Crisis
The SEC initiated an emergency enforcement action against an asset manager who allegedly boasted remarkable investment success throughout the global financial crisis while allegedly exaggerating the value of the assets he managed and concealing major losses from investors. The SEC sought and obtained a freeze of U.S.-based assets belonging to Nikolai Battoo and two of his companies in order to prevent additional harm to U.S. investors. In addition to Battoo and his companies, the SEC charged Tracy Lee Sunderlage, an unregistered broker-dealer who was banned from the industry in a previous SEC enforcement action, for his involvement with Battoo's investment program.

The SEC alleged that Battoo claimed to manage $1.5 billion on behalf of investors around the world, including at least $100 million for U.S.-based investors. The SEC further alleged that contrary to Battoo's proclaimed track record of exceptional risk-adjusted returns for his investors, he actually suffered major losses in 2008 due to his investments in the Bernard Madoff Ponzi scheme and a failed derivative investment program. Rather than admit the losses to investors, Battoo allegedly overstated the value of his investments in a variety of ways. According to the SEC, instead of paying investors who requested redemptions, Battoo provided a series of excuses, including saying that certain counterparties had frozen the assets he managed based on investigations by U.S. government agencies, and that his attorneys were negotiating a "release" with the SEC. Prior to the SEC's recent filing of a complaint, however, Battoo's assets were not frozen and he was not negotiating any release with the SEC.

Sources: SEC Charges Asset Manager Lied to Investors, Hid Major Losses While Boasting Remarkable Performance During Financial Crisis, SEC Press Release 2012-185, September 7, 2012; U.S. Securities and Exchange Commission vs. Nikolai S. Battoo, BC Capital Group S.A. (Panama), BC Capital Group Limited (Hong Kong) and Tracy Lee Sunderlage, U.S. District Court for the Northern District of Illinois, September 6, 2012.

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