SEC Retail Investor Focus Turns Towards Registered Investment Companies
Earlier this year when the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) announced its 2018 examination priorities, OCIE stated that a core priority was to protect retail investors, including seniors and individuals saving for retirement. OCIE is now continuing this effort by focusing on mutual funds and exchanged-traded funds (together, the “Funds”) as the vehicles in which retail investors invest.
In a Risk Alert issued by OCIE on Nov. 8, the office announced that it is initiating a series of examinations focused on Funds. The goal of the examinations is to “assess industry practices and regulatory compliance in certain areas that may have an impact on retail investors.” The examinations, however, are not limited to just Funds; OCIE may also evaluate advisers and sub-advisers (collectively, “Advisers”) to Funds and review the oversight of a Fund’s Board. OCIE stated that Funds, Boards and Advisers in the following categories will be the subject of its reviews:
- Index funds that track custom-built indices
- Smaller ETFs and/or ETFs with little secondary market trading volume
- Mutual funds with higher allocations to certain securitized assets
- Funds with aberrational underperformance relative to their peer groups
- Advisers relatively new to managing mutual funds
- Advisers who provide advice to both mutual funds and private funds that have similar strategies and/or are managed by the same portfolio managers (side-by-side management).
Further, OCIE provided additional guidance as to the scope of its reviews for each of the above-categories in the Risk Alert. The additional guidance focuses on Fund and Adviser policies and procedures specific to each category and provides a roadmap for policy considerations and reviewing controls. The guidance also identifies certain elements of each category that pose unique risk and/or conflicts and Board oversight expectations.
What does this mean for Funds, Boards and Advisers? Funds and Boards should review their policies, procedures and disclosures and those of a Fund’s service providers to confirm that they are designed to address risks and conflicts, that appropriate controls have been implemented, that such controls are operating as intended and that disclosures clearly state risks and conflicts. Additionally, Funds’ Boards should assess the reports they receive to verify that they have sufficient information to oversee the Funds’ operations.
CSS can assist Funds, Board and Advisers by conducting independent assessments of the focus areas that OCIE has identified. Contact us to tailor an engagement designed to fit your needs and those of your Funds.
SEC Alerts Investment Advisers to Review Solicitor Arrangements
On October 31, OCIE issued a new Risk Alert for investment advisers with solicitor arrangements. The SEC periodically releases risk alerts to notify the industry of deficiencies they are finding during examinations, and this latest alert puts investment advisers with solicitor arrangements on notice to check their solicitor agreements, policies and procedures, and disclosure documents.
Key deficiencies cited in the alert include:
- Solicitor disclosure documents – Third-party solicitors did not provide solicitor disclosure documents to prospective clients or provided disclosure documents that did not contain all required information.
- Client acknowledgements – Advisers did not timely receive a signed and dated client acknowledgment of receipt of the adviser brochure and the solicitor disclosure document.
- Solicitation agreements – Cash fees were paid to a solicitor without a solicitation agreement in effect or pursuant to an agreement that did not contain certain specific provisions.
- Bona fide efforts to ascertain solicitor compliance – No bona fide effort was made by the adviser to ascertain whether third-party solicitors complied with solicitation agreements and appeared to not have a reasonable basis for believing the solicitor was in compliance.
OCIE also noted related deficiencies under Advisers Act Rule 206(1) and 206(2) where firms recommended service providers to clients in exchange for client referrals without disclosing the conflict.
Firms with solicitor arrangements are encouraged to review the risk alert and should consider the following dos and don’ts:
| Area of Focus | DOs | DON’Ts |
| Solicitor disclosure document |
√ Disclose the nature of the relationship, including any affiliation, between the solicitor and adviser √ Specify the actual compensation terms agreed upon in the solicitor arrangement √ Disclose any additional solicitation cost the client will be charged on top of the advisory fee |
Χ Don’t use vague or hypothetical terms to describe the solicitor’s compensation. |
| Client acknowledgement of disclosure documents |
√ Include the client acknowledgement with the investment advisory contract and/or other new account paperwork √ Make sure new business processing procedures include a step to check for a signed and dated client acknowledgement from solicited clients |
Χ Don’t accept an investment advisory contract from solicited clients without a written acknowledgement of receipt of the firm’s disclosure documents Χ Don’t accept client acknowledgements that are undated or dated after the client entered into the advisory contract |
| Solicitation agreements |
√ Make sure the solicitor agreement includes an undertaking by the solicitor to perform its responsibilities consistent with instructions received by the adviser √ Describe the solicitor’s activities and compensation √ Require the solicitor to provide to clients and prospective clients a copy of the adviser’s Form ADV Brochure and the solicitor disclosure document |
Χ Don’t pay fees to a solicitor without an executed solicitor agreement on file |
| Ascertain solicitor compliance |
√ Regularly review solicitor practices for compliance with the solicitor agreement √ Have third-party solicitors complete an annual attestation of compliance with the solicitor agreement and Cash Solicitation Rule √ Periodically sample fee payouts to solicitors to ensure compensation disclosures continue to be accurate |
Χ Don’t set it and forget it |
| Form ADV disclosures |
√ Disclose in the Form ADV brochure any conflicts related to recommending service providers to clients in exchange for client referral |
Χ Don’t use ambiguous language when disclosing conflicts arising out of solicitation arrangements. |
Pennsylvania Sounds Warning Bell Over Client Credentials and Custody
The Pennsylvania Department of Banking and Securities (PDOBS) has indicated in recent guidance two concerns related to investment advisers using client credentials to access a custodial account(s). In the letter dated September 25, 2018, PDOBS indicates that the use of client credentials may create custody and is considered to be a dishonest and unethical practice.
First, PDOBS notes the same custody concern addressed by the SEC in Question II.6 of the SEC’s published responses to frequently asked questions. Client credentials that provide an adviser with account access going beyond the ability to trade the account and access information may be custody. The authority to disburse assets or change an address absent applicable custodial controls is custody and requires surprise examination procedures.
Second, PDOBS “considers Registrants using client usernames and/or passwords to access client custodial accounts as a dishonest and unethical practice.” PDOBS indicates that because an adviser’s use of client credentials could invalidate user access agreements with custodians and falsely represents the user that the practice must be discontinued.
To rectify this issue, Pennsylvania-registered advisers are instructed to notify clients to change usernames and client passwords.
We are not aware of other similar conclusions by state regulators. We feel the SEC has tacitly approved the practice through its FAQs but that is surely not a definitive position. This bears watching for all advisers.
For advisers who use client credentials that create custody and plan to have surprise exams of those accounts, another custody problem may arise: custodians may not support delivering to accountants the account statements covering those accounts in which the adviser is not listed in the custodian’s books as a representative of the client. The accountant may be forced to attempt to retrieve statements directly from clients, which can be an arduous path.
While adviser access is a natural function at large retail custodians, other locations of client assets are still evolving to include those functions. Brokers designed to service only internal agents, state 529 plan custodians, and 401k administrators are examples of where advisers’ only choice to access accounts is through the client credentials. As an adviser, consider making inquiries to any custodian or administrator for adviser-specific access to client accounts. We are seeing more professionally managed access opening up, and PA’s position will create an even greater need.
The Current State of Market Manipulation In Financial Markets
Just a couple decades ago, our market infrastructure was dominated by only a handful of securities exchanges. Fast forward to the present day, and there are now 18 national securities exchanges registered with the Securities and Exchange Commission (SEC) under Section 6(a) of the Securities Exchange Act of 1934 (“Exchange Act”), 44 Alternative Trading Systems (ATS) and over 200 brokerdealers that internalize their customers’ trades. We have witnessed one of the greatest decentralizations of our market microstructures in the same period of time in which global derivatives markets have experienced unprecedented growth. What we are left with is an overly complex market, a flourishing over-the-counter (OTC) and exchange traded derivatives market worth more than $700 trillion in outstanding notional value, and a financial system ripe for abuse. As our financial markets evolve, the types of trading activities used by market manipulators will adapt in response, and if regulators don’t follow these adaptations closely, the rules and regulations designed to protect investors from such manipulations risk becoming obsolete. With an already limited scope of application, prohibitions against market manipulations often filter manipulators who employ outright criminal means of manipulation, while letting those who use legitimate transactions to manipulate the market pass through the sieve. In this article, we will broadly discuss the inadequacies of enacted rules and regulations in addressing the current state of market manipulation in financial markets, and illustrate these shortcomings with real cases found under three main topics: open-market manipulations, information- based manipulation schemes, and order-based manipulations.
Social Engineering & Ransomware
If you were asked to describe a hacker, what image comes to mind? If you’re like most, you are probably picturing unintelligible text flying across a monitor as young men in black hoodies attempt to break into networks, engaging in a very technical dance and speaking in terms the average layperson would not understand. While that may be an apt description of the hacker of yesterday, today one of the most effective means of hacking is surprisingly the least technical. It is called social engineering, and it can be loosely defined as manipulating a person to perform an action or to divulge information.
Rather than trying to break into your computer, the hackers are finding it far easier to simply trick you into handing over login information. A common example of social engineering is a hacker impersonating someone in a position of authority in an attempt to obtain someone’s password.
Diminished Capacity: How an Investment Adviser Can Protect Their Elderly Clients
All too often, we hear how another elderly investor was taken advantage of by some type of fraudster. Even more frequently, we receive queries from registered investment advisers (“RIAs”) asking what they can do about an elderly client they feel is being financially abused by a caregiver or who is suffering from diminished capacity challenges.
Unfortunately, this difficult and sensitive issue is likely to become more common as the ranks of older seniors grow; a recent study published by the National Institute on Aging reveals that impaired cognition affects approximately 20 percent of people aged 85 years or older. Investment advisers often lack the tools to help their senior clients and risk liabilities, such as breaches of privacy. But there are proactive steps an adviser can take at the onset of a senior client relationship and throughout its course than can benefit a senior client and mitigate liabilities to the advisers.
Throughout this article we provide information on the red flags of diminished capacity, warning signs of elder financial abuse, and guidance on steps registered investment advisers can take to protect senior clients and the RIA’s business.