August 2024 Regulatory Roundup
More Flack on WhatsApp, Hypothetical Performance SmackDown, A Timely Warning on the Pay-to-Play Rule, and Updates to Qualifying Venture Capital Fund Exemption
This month’s big news from the SEC was more piggy-bank breaking fines against 26 broker-dealers, investment advisers and dual registrants for “widespread and longstanding failures” for using unapproved electronic communications methods, known as “off-channel communications.” The SEC’s Marketing Rule (Advisers Act 206(4)-1) enforcement continued with a settlement involving an investment adviser for using hypothetical performance on its public website. Next, in a case undoubtedly meant to serve as a warning for advisers after Minnesota Governor Tim Walz was added to the Democratic presidential ticket, the SEC fined an adviser $95,000 for a $7,150 campaign contribution made in violation of the “look back” provision under the Pay-to-Play Rule (Advisers Act Rule 206(4)-5). New rule making activity was less dramatic as the SEC adopted a final rule increasing the dollar threshold for defining a “qualifying venture capital fund” under the Investment Company Act of 1940 from $10 million to $12 million.
26 More Firms Slammed with $390 Million in Fines for Failure to Retain Texts and Chats
It’s becoming an all-too-familiar story: the SEC fined 26 broker-dealers, investment advisers and dual registrants for failing to prevent their employees from texting and using other “off-channel” communications to discuss business with colleagues and clients. As usual, most of the firms were broker-dealers, since their record-keeping requirements for business communications are much broader than those applicable to investment advisers. The fines ranged from $400,000 to $50 million.
In these cases, the firms had policies and procedures that prohibited off-channel communications. However, employees at all levels of authority failed to follow the firms’ policies prohibiting the use using off-channel communications. Moreover, the firms were also hit with failure to supervise charges because they did not monitor compliance with these policies.
The SEC highlighted the fact that three of the 26 firms self-reported their violations to the SEC and received lesser penalties than the others. However, it is hard to see much difference in the penalties received by the self-reporters since all firms were required to pay significant fines and admit to violations of the record-keeping and supervisory rules under the Exchange Act and Advisers Act. All were also required to engage compliance consultants to review their policies on electronic communications.
The lessons from this latest slew of settlements include:
- Research which communication channels your employees use with their colleagues and clients. Firms should know client preferences and update their technology to capture preferred communication platforms.
- Be proactive by addressing the gaps in firm policies and procedures now. It’s clear the SEC will be looking at firm compliance with record-keeping requirements in all examinations.
- Educate employees and clients about the importance of using official channels for business communications. Conduct regular training sessions with employees so they understand what is at stake when they use unapproved communication channels. Discuss with clients the need for the firm to maintain appropriate records and to protect their private financial information by using approved channels.
- Institute monitoring of the use of off-channel communications by firm employees. Specifically, look for indications in current communications that employees plan to move off-channel. Firms should also be aware of significant drops in employee communication volume, which could signal a move to off-channel messaging. But check with outside counsel before asking employees to hand over their personal mobile devices for review to avoid running afoul of any state or federal private regulations.
- Check the tone at the top. The SEC’s settlement orders highlighted senior managers’ frequent failure to comply with their firm’s policies and procedures by using unapproved communication channels.
Adviser Ordered to Stop Using Hypothetical Performance on Public Website
The SEC’s Marketing Rule exam sweep exposed a firm’s use of hypothetical performance on its website in violation of Advisers Act Rule 206(4)-1. The SEC imposed a $430,000 fine against a registered investment adviser (the “Adviser”) for violating the Marketing Rule.
The Marketing Rule, which became effective November 4, 2022, provides that registered investment advisers cannot use hypothetical performance in their advertisements unless the firm implements policies and procedures reasonably designed to ensure that the performance is relevant to the financial situation and investment objectives of the intended audience. In this case, the Adviser showed performance information developed from its model portfolios on its publicly available website. Unfortunately, the firm failed to have the required policies and procedures in place as required under the rule.
The use of hypothetical performance has always been an SEC hot button, and the Marketing Rule gives the SEC additional ammo to be used against advisers in settlement actions. In September 2023, the SEC brought charges against nine registered investment advisers for their use of hypothetical performance on their websites. Like the most recent case, the advisers used hypothetical performance on their websites but failed to implement the required procedures to ensure that the performance was relevant to the likely financial situation and investment objectives of the intended audience. The firms paid $850,000 in combined penalties. The SEC also imposed aggregate fines of $200,000 and other sanctions on five registered investment advisers in April 2024 for using hypothetical performance on their public websites, again without having the required policies and procedures.
Although the SEC did not provide specifics on the hypothetical performance being used, it sounds like the firms created model portfolios using blended performance based on actual returns or underlying investments. Some firms offer collections of investments, known as model portfolios, that include mutual funds or ETFs. These model portfolios blend asset classes and investment strategies to create a diversified portfolio to meet a specific financial goal. Firms may create marketing materials to show potential investors the historical performance of this model. Under the Marketing Rule, however, hypothetical performance is defined as “performance results that were not actually achieved by any portfolio of the investment adviser,” including performance derived from model portfolios.
The bottom line is that the SEC does not want investment advisers using hypothetical performance with retail clients and consequently included significant guardrails around its use in the New Marketing Rule. Firms using hypothetical performance should review their current practices and make sure they comply with the New Marketing Rule to the letter.
Adviser Pays $95,000 Fine for Pay-to-Play Foot Fault in a Timely Reminder this Election Season
For firms that provide advisory services to government entities, the Advisers Act Rule 206(4)-5, the “Pay-to-Play” Rule, can be a major headache. The rule limits investment advisers, including exempt reporting advisers, from making political contributions to state and local government officials and candidates with the authority to influence the selection of an investment manager for a public pension fund. The rule imposes an onerous penalty with a long lifespan – investment advisers are prohibited from receiving compensation for managing a government entity’s investments for two years after either the firm, a “covered associate” or a political action committee (PAC) they control, makes a political contribution to a state or local official who can influence the hiring of the investment adviser. The rule allows an adviser or “covered associate” to make de minimis contributions of $350 per election cycle for candidates running for offices that the covered associate can vote for and $150 for other candidates. The rule does not apply to contributions to federal officials and candidates, except when the state or local official is running for federal office. Covered associates include employees who solicit government entities for the adviser.
Recent Case
In this case, the SEC settled with an adviser who was the sponsor and adviser to a private fund. The Michigan Public Employees’ Retirement Fund made a $100 million commitment to invest in the fund in 2017 (see a similar case here). The adviser ran afoul of the Pay-to-Play Rule by hiring an individual who made a $7,150 campaign contribution to a Michigan government official, presumably Michigan’s governor, in December 2019. The individual made this contribution more than six months before getting hired by the firm for a position that would be considered a “covered associate” under the rule. After being hired, the individual asked for, and got, the contribution returned. These facts indicate that the firm had a policy and procedure to comply with the Pay-to-Play Rule and vetted the employee before hire. It is also fair to assume that the firm asked the employee to request the contribution return.
There are some exceptions to the rule, including one for returned contributions. In this case, however, the covered associate’s contribution exceeded the $350 limit and was not returned within 60 days after the firm learned of the contribution as required.
In this situation, the campaign contribution triggered the rule’s two-year look-back provision because the new employee was a covered associate. This meant that the adviser could not receive compensation for its advisory services for the government entity for two years because of the covered associate’s campaign contribution, which was made six months before hire.
Exceptions and Exemptive Orders
As previously stated, the rule has a few narrow exceptions. In addition to the one for returned contributions, there is an exception for new covered associates. Contributions made by an individual more than six months before becoming a covered associate of an investment adviser do not trigger the rule. If, however, the associate solicits clients for the adviser, then the two-year look-back applies.
Advisers have another avenue for avoiding the severe consequences of the Pay-to-Play Rule, the exemptive process. The SEC has been willing to issue exemptive orders to firms with robust compliance programs that promptly address contributions made in violation of the Pay-to-Play Rule (see Advisers Act Release No. 6224, Advisers Act Release No. 6244, and Advisers Act Release No. 6221). This route may be less palatable since the process is public, requires the assistance of legal counsel, takes time, and requires the firm to live with additional conditions the Commission imposes.
Effect of Walz on Democratic Ticket
With Governor Walz on the Democratic ticket for vice president, firms that either provide or intend to provide advisory services to Minnesota government entities, such as a public employee pension fund, should be aware of the potential for violating the Pay-to-Play Rule if they, or their covered associates, intend on contributing to the Harris campaign. These firms must consider whether (i) the Minnesota Governor is directly or indirectly responsible for, or can influence, the outcome of, the hiring of an investment adviser by that Minnesota government entity, or (ii) has the authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by that Minnesota government entity.
Compliance Tips for the Pay-to-Play Rule
Just in case you are a little rusty on the application of the Pay-to-Play Rule, here are our compliance tips:
- Identify governmental entities. Advisers must be able to identify government entities they serve along with any government entities invested in or solicited to invest in private funds managed by the firm. Identification of government entities should be part of the client onboarding process. Advisers Act Rule 204-2 requires that a firm maintain a list of all government entities to which the adviser has provided investment advisory services in the past five years.
- Identify covered associates and applicable look-back time frames. The SEC views the definition of covered associate very broadly. This includes general partners, managing members and executive officers and others with similar status or function. It also includes any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employees. A political action committee (PAC) controlled by the investment adviser is also a covered associate. In the Final Release for Rule 206(4)-5, the SEC said, “[a]n employee need not be primarily engaged in solicitation activities to be a “covered associate” under the rule.” Firms should consider all employees and independent contractors who are involved in the sales and relationship management process to be “covered persons.”
- Institute pre–clearance processes for campaign contributions. Because of the rule’s complexity, we recommend that firms that solicit government business require all employees to obtain approval before making a “campaign contribution” (see next point for more details), whether it is a local or state election. Contributions to candidates for federal office are not covered unless they happen to be state or local officials at the time of the contribution.
- Understand that “campaign contributions” are broadly defined. Campaign contributions include not only money but in-kind contributions such as payment for services or use of facilities, personnel or other resources to benefit any federal, state or local candidate campaign, political party committee, or other political organization, including a successful candidate’s inaugural committee or transition team. Volunteering to work on a campaign outside of working hours is not considered a campaign contribution but may be subject to firm pre-approval.
- Pre-employment and new “covered associate” vetting for campaign contributions. Firms should be aware of any contributions made by individuals within two years of becoming a covered associate, regardless of whether the individual was employed by the firm when the contribution was made. The look-back period is only six months for employees who are not involved in soliciting clients. The vetting should take place before hiring or promotion.
- Verify whether donations to PACs and political parties are allowed. Although contributions to a political party or non-adviser affiliated PACs do not usually trigger the Pay-to-Play Rule, the rule prohibits firms from circumventing the intent of the rule. Therefore, firms should consider a written representation from a PAC that the contributions will not be earmarked for a specific candidate or will only be spent on overhead costs associated with the PAC’s operations.
- Institute Periodic Testing. The firm’s compliance program should include periodic testing to ensure that employees are not making political contributions in violation of its policies and procedures. OpenSecrets.org is a free database that provides data on donors to local political campaigns.
- Consider state and local laws. Many states and municipalities have adopted laws and regulations limiting how investment managers can solicit investment advisory business. Make sure your firm understands and complies with these rules.
Venture Capital Funds Adjustment for Inflation
Unlike many of the SEC’s recent rules, the SEC’s proposal to adopt new Rule 3c-7 under the Investment Company Act received only two comments and has relatively little impact on the venture capital market. The final rule increases the dollar threshold for defining a “qualifying venture capital fund” under Section 3(c)(1)(C) of the Investment Company Act from $10 million to $12 million. The SEC was required to adjust this dollar threshold for inflation under the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018. The new rule becomes effective 30 days after publication in the Federal Register.
For the uninitiated, a company that is in the business of “investing, reinvesting or trading securities” must register with the SEC as an investment company under the Investment Company Act of 1940. Registration is expensive, requires compliance with legal reporting and disclosure requirements, and subjects the investment company to the SEC’s regulatory oversight. There are exceptions to registration requirements for investment companies. Section 3(c)(1) exempts private funds with no more than 100 beneficial owners who qualify as accredited investors. A private fund may have up to 250 beneficial owners if it meets the definition of a “qualifying venture capital fund.” A qualifying venture capital fund is a private fund that pursues a capital strategy, invests no more than 20% of its committed capital in non-qualifying investments, restricts borrowing and leverage to 15% of the fund size, and limits limited partner redemption rights to extraordinary circumstances.
Photo by Didier VEILLON on Unsplash
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Table of Contents
Tips for Updating Your Compliance Program in 2025
In addition to basic blocking and tackling, compliance officers often have the thankless job of performing the annual review of their compliance program required by Advisers Act Rule 206(4)-7. As discussed in our blog post, Write the Best Annual Compliance Program Review Ever!, that review should consider changes to the Advisers Act and applicable regulations, legal proceedings and guidance from regulators, including risk alerts and interpretations. To simplify the task of collecting all of this information, I’ve identified the top regulatory hot buttons to help advisory firms update their compliance programs for 2025. This is not an exhaustive list; instead, it is the highlight reel of SEC focus areas.
Advisers’ Year-End Checklist for 2024
Compliance officers love checklists, so we’ve put together some “to dos” to consider completing before the end of the year. Enjoy! Get out Your Checkbook
Regulatory Roundup for October and November 2024
Things have perked up this month, with EXAMS’ release of its 2025 priorities and publication of a new FAQ on Form PF’s compliance deadlines. The SEC also settled with two advisers on “greenwashing” charges, presumably resulting from EXAMS promise in its 2020 Exam Priorities to review “the accuracy and adequacy of disclosures provided by RIAs offering clients new types or emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate environmental, social, and governance (ESG) criteria.” I also could not resist including two cases from September. The first case includes a textbook example of the issues raised when cross-trading illiquid fixed-income securities. The second case provides a rare example of the SEC pursuing a firm for failing to register because of operational overlap.
September Surprise: SEC Finds Gaps in MNPI Controls for CLO Manager
In the SEC’s burst of settlements at the end of its fiscal year, one case about the potential misuse of material nonpublic inside information (“MNPI”)
Regulatory Roundup for September 2024
FinCEN added to advisers’ compliance burden this month by imposing new anti-money laundering policies and procedures for January 1, 2026. The SEC also ended its fiscal year with more heart attack-inducing fines against 11 broker-dealers, investment advisers and a dual registrant for “widespread and longstanding failures” for using unapproved electronic communications methods, known as “off-channel communications.” In a surprise move, the Commission announced the first settlement where an adviser received no penalty for its record-keeping failures, presumably because of its self-reporting and selflessness by helping the SEC build a case against another firm. The SEC also continued its “broken windows” regulatory approach by announcing settlements with 11 investment managers for failing to file Form 13F and 13H with civil penalties exceeding $3.4 million. We wrap up with a case showing that the SEC has not given up on its assault on private funds, charging a firm with fraud for singling out some of its investors for preferential treatment.
Nine More Advisers Face $1.24 Million Fallout from SEC’s Marketing Rule Sweep
September 30 is the SEC’s fiscal year-end, so it’s no surprise to see an uptick in enforcement cases this month. The latest slew of settlements
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