Financial Services Alert - May 24, 2011

The SEC issued an order (the “Order”) settling administrative proceedings against a registered investment adviser (the “Adviser”), its chief executive officer (the “CEO”) and its chief compliance officer until February 2010 (the “CCO”) relating to SEC findings that (a) the Adviser had provided incorrect responses to inquiries from prospective clients about the Adviser’s experience with SEC examinations; (b) the Adviser had failed to comply with Rule 206(4)‑2 (the “Custody Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”) with respect to its two “private hedge funds;” and (c) the Adviser had failed to comply with Advisers Act requirements regarding annual acknowledgement of the Adviser’s code of ethics by the Adviser’s employees.  This article provides highlights of the SEC’s findings, which the respondents neither admitted nor denied. 

Background.  The CEO and the CCO co-founded the Adviser in 1997.  The Adviser is a registered investment adviser managing approximately $7 billion for retail and institutional clients and two hedge funds.  During the relevant period, the CEO managed all aspects of the Adviser and was solely responsible for all investment decisions.  The CCO, who also served as the Adviser's general counsel and CFO, was primarily responsible for directing the Adviser’s backroom operations.

Failure to Disclose SEC Examination Findings.  The SEC found that between 2005 and 2008 the Adviser gave incorrect responses to requests for proposal (“RFPs”) from clients and prospective clients inquiring about whether the Adviser had received any “findings,” “deficiencies,” or “corrective actions required” in connection with an SEC examination.  Although it had received a 7-page deficiency letter addressed to the CCO following a 2005 examination, the Adviser responded to the foregoing RFP’s variously by (1) stating that there were no significant findings in its most recent SEC examination; (2) not answering the question; (3) referring the client or prospective client to the Adviser’s broker-dealer subsidiary; and/or (4) providing a copy of an SEC deficiency letter and reply for the broker‑dealer affiliate.  The SEC also took issue with the Adviser’s implementation of its compliance policies under which the CCO was supposed to review responses to RFPs to correct misleading statements.  The SEC noted that the Adviser made a concerted effort in 2005-2008 to attract institutional clients with the result that assets under management grew from $225 million in 2005 to over $9 billion in 2008.

Custody Rule Compliance.  The SEC found that having elected to comply with the Custody Rule with respect to its two hedge funds by distributing annual audited financial statements to the fund investors within 120 days of fiscal year end, the Adviser had failed to meet the 120-day deadline from 2003 to 2008, with financial statements delivered to investors from 1½  to 14 months late.  The SEC attributed the late delivery of financial statements to a variety of factors, including failure to pay the funds’ auditors in a timely manner, not having the funds’ books and records properly organized for fund auditors, problems with portfolio management software and the CEO’s and CCO’s desire to complete other audits or reviews first.

Code of Ethics Acknowledgements.  The SEC found that the Adviser had failed to secure employee acknowledgements of receipt of the Adviser’s code of ethics as required by the code and failed to maintain those acknowledgements as required under Advisers Act Rule 204A-1.  From 2005 through 2007, the Adviser did not secure any of the required acknowledgments and, for 2008 and 2009, only secured acknowledgments from two employees.  Between 2005 and 2009, the Adviser had between 14 and 28 employees.  Although advised in the 2005 deficiency letter about the lack of any employee annual acknowledgements with respect to the Adviser’s code of ethics, and despite having adequate time to secure acknowledgements, the Adviser failed to correct the deficiency by year end.  The SEC further noted that despite have received a second deficiency letter from the SEC examination staff in 2008 citing the failure to secure employee acknowledgements of the Adviser’s code of ethics, the Adviser failed to secure code of ethics acknowledgements from its employees in 2008 and 2009.

Remedial Efforts and Sanctions.  In determining to accept the offer of settlement, the SEC considered certain remedial actions, including cooperation afforded the SEC staff and the Adviser’s decision to (i) hire an independent consultant during the course of the SEC’s investigation to evaluate its compliance practices and procedures and (ii) implement the consultant’s recommendations.  Among other sanctions, the SEC ordered the Adviser to pay a civil penalty of $200,000 and the CEO and CCO to each pay civil penalties of $100,000, and the Adviser to continue its engagement of the compliance consultant.  The SEC also ordered the Adviser to incorporate a significant portion of the Order, including the SEC’s detailed findings regarding violations of the Advisers Act, into the Adviser’s Form ADV, which the Adviser was to send to each of its existing clients and to any new client that engages the Adviser or the CEO in the following year.  The Order also requires the Adviser to post a copy of the Order on the Adviser’s website for a period of six months.

The OCC issued an interpretive letter (“ Letter 1131”) in which it concluded that a national bank (the “Bank”) could meet its obligation to dispose of a parcel of DPC real property (the “DPC Property”), i.e., a property acquired by the Bank in connection with a debt previously contracted, by transferring the DPC Property to a limited partnership wholly-owned by the Bank’s Community Development Corporation (“CDC”) subsidiary (the “CDC Subsidiary”). 

The DPC Property was a Low-Income Housing Tax Credit development project that the Bank acquired by deed in lieu of foreclosure.  Although the Bank held the DPC Property pursuant to its authority to hold DPC assets (its “DPC Authority”), the OCC states that the DPC Property is also a permissible public welfare investment because it primarily benefits low- and moderate-income individuals.  Under the Bank’s DPC Authority, it would generally be required to dispose of the DPC Property within five years of its acquisition.  Letter 1131, however, concludes that the Bank can accomplish the required “disposition” by transferring the DPC Property to the CDC Subsidiary because the CDC Subsidiary’s business is to make public welfare investments such as investments in the DPC Property.  Accordingly, the Bank can, by using the CDC Subsidiary, extend the Bank’s holding and development period for the DPC Property beyond the five-year period allowed under the Bank’s DPC Authority.

The CFTC adopted amendments to its regulations, essentially as proposed, that (a) codify prior exemptive relief from certain disclosure, reporting and recordkeeping requirements for commodity pool operators (“CPOs”) whose commodity pool units of participation are publicly offered and listed for trading on a national securities exchange (“Commodity ETFs”) and (b) provide an exemption from registration as a CPO for certain independent directors or trustees of Commodity ETFs.  Commodity ETFs seek to track the performance of a specific commodity index or alternatively, actively trade commodity interests without regard to an index or benchmark.  The CFTC has previously provided exemptive relief on a case-by-case basis to Commodity ETFs subject to compliance with conditions like those reflected in the Rule 4.12 amendments the CFTC has adopted.  Actively managed Commodity ETFs must have independent directors or trustees in order to meet exchange listing standards that implement audit committee independence requirements mandated in SEC Rule 10A-3 under the Securities Exchange Act of 1934 adopted pursuant to the Sarbanes-Oxley Act of 2002.  The amendments to Rule 4.13 adopted by the CFTC provide an exemption from CPO registration, subject to certain conditions, for an independent director or trustee of a Commodity ETF who serves solely so that the Commodity ETF can meet the audit committee requirements of Rule 10A-3. 

The amendments become effective on June 17, 2011.

The SEC approved a FINRA proposal to amend new FINRA Rule 5131 (New Issue Allocations and Distributions) that simplifies, and delays implementation of, the Rule’s so‑called spinning prohibition, and also delays implementation of the rule’s provision prohibiting members from accepting market orders for the purchase of IPO shares in the secondary market prior to the commencement of trading for the IPO shares.  The implementation date for both provisions is delayed from May 27, 2011 to September 26, 2011.  The other provisions of the Rule will become effective on May 27, as originally scheduled.  For a more detailed description of the proposal approved by the SEC, see the April 19, 2011 Alert.

The SEC issued a 517-page release proposing (i) amendments to existing rules and (ii) new rules, that would apply to credit rating agencies registered with the SEC as nationally recognized statistical rating organizations (“NRSROs”).  The release also proposes (a) a new rule and form that would apply to providers of third-party due diligence services for asset-backed securities (“ABS”) and (b) amendments to existing rules and a new rule that would require issuers and underwriters of ABS to make publicly available the findings and conclusions of any third-party due diligence report they obtain.  Portions of the proposed changes are designed to comply with SEC rulemaking mandates in the Dodd-Frank Act, while others expand on self-executing provisions of the Dodd-Frank Act.  Comments on the release are due no later than 60 days after its publication in the Federal Register.