Financial Services Alert - February 18, 2014

On January 31, 2014, the SEC Division of Trading and Markets issued a no-action letter to Faith Colish and five other lawyers providing relief from broker-dealer registration for M&A Brokers engaged in activities related to the purchase or sale of a privately held company (the “M&A Broker Letter”).  The term “M&A Broker” is defined, for purposes of the letter, as “a person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company through the purchase sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or the business conducted with the assets of the company.”

The M&A Broker Letter represents a new direction in guidance for unregistered persons advising companies in M&A transactions.  The two prior no-action letters in the area, International Business Exchange Corporation, SEC No-Action Letter (pub. avail. Dec. 12, 1986) and Country Business, Inc., SEC No-Action Letter (pub. avail. Nov. 8, 2006), focused on the question of whether the broker was engaged in the business of effecting transactions in securities and placed limitations on the way the broker could be paid and the ability of the broker to negotiate a securities transaction in connection with the sale of a business.  The M&A Broker Letter, by contrast, permits the M&A Broker to be engaged in the business of effecting securities transactions in connection with its business as an M&A Broker provided the conditions of the letter are met.

Additional definitions

The M&A Broker Letter uses the following additional defined terms:

• Privately held company:  a company that does not have any class of securities registered, or required to be registered, with the SEC under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”), or with respect to which the company files, or is required to file, periodic information, documents, or reports under Section 15(d) of the Exchange Act.  A privately held company subject to the letter must be an operating company that is a going concern and not a shell company.
• Shell company:  a company that (1) has no or nominal operations and (2) has (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.
• Business combination related shell company:  a shell company that is (1) formed by an entity that is not a shell company solely for the purpose of changing the corporate domicile of that entity solely within the United States or (2) formed by an entity defined in Section 165(f) of the Securities Act of 1933 (the “Securities Act”) among one or more entities other than the shell company, none of which is a shell company.
• Control:  a buyer, or group of buyers collectively, will have the necessary control of a company following the M&A transaction if it has the power, directly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract or otherwise.  The necessary control will be presumed to exist of, upon completion of the transaction, the buyer or group of buyers has the right to vote 24% or more of a class of voting securities; has the power to sell or direct the sale of 25% or more of a class of voting securities; or in the case of a partnership or limited liability company, has the right to receive upon dissolution, or has contributed, 25% or more of the capital.

Conditions to Acting as an M&A Broker

The M&A Broker Letter lists the following 10 conditions to the availability of relief from broker-dealer registration for an M&A broker:

1. The M&A Broker must not have the ability to bind a party to an M&A transaction.
2. An M&A Broker may not, directly or indirectly through any of its affiliates, provide financing for an M&A transaction.  An M&A Broker may assist purchasers in obtaining financing from unaffiliated third parties and must disclose any compensation in connection with the financing in writing to the client.
3. The M&A Broker may not have custody, control or possession of, or otherwise handle, funds or securities issued or exchanged in connection with the M&A transaction or other securities transaction for the account of others.
4. The M&A transaction may not involve a public offering.
5. To the extent an M&A Broker represents both buyers and sellers, it will provide clear written disclosure as to the parties it represents and obtain written consent from both parties to the joint representation.
6. If the M&A transaction will involve a group of buyers, the M&A Broker may not assist in forming the group of buyers.
7. The buyer, or group of buyers, will, upon completion of the transaction, control the company (as defined in the letter) and actively operate the company or business conducted with the purchased assets.
8. No M&A transaction may result in the transfer of interests to a passive buyer or group of passive buyers.
9. Any securities received by the buyer or M&A Broker in an M&A transaction will be restricted securities within the meaning of Rule 144(a)(3) under the Securities Act because the securities will have been issued in a transaction not involving a public offering.
10. The M&A Broker (and, if the M&A Broker is an entity, each officer, director or employee of the M&A Broker): (i) has not been barred from association with a broker‑dealer by the SEC, FINRA or any state regulator and (ii) is not suspended from association with a broker-dealer.

State Law Regulation Not Affected

State laws requiring registration as a broker or dealer are not preempted or otherwise affected by the SEC no-action letter.  M&A brokers will need to determine whether they have exemptions or exclusions available in any state where they plan to do business, or register with the state securities administrator.

M&A Brokers, SEC No-Action Letter (pub. avail. January 31, 2014 (revised Feb. 4, 2014)).

The SEC settled public administrative proceedings against Navigator Money Management (the “Adviser”), a registered investment adviser, and its principal, Mark A. Grimaldi (the “Principal”), over advertisements in newsletters and on websites making claims about the success of the Principal’s investment advice and of a mutual fund the Principal managed (the “Fund”).  This article provides a high-level summary of the SEC’s detailed findings as set forth in the settlement order (the “Order”), which the Adviser and its Principal (together, the “Respondents”) have neither admitted nor denied.

Background

The Principal is the president, chief compliance officer, and majority owner of the Adviser which reported $115 million in “regulatory assets under management” in its most recent Form ADV and has approximately 600 advisory clients.  The Principal manages both the Adviser’s individual client accounts and the Fund.  The Principal also is the majority owner of the entity that published the Newsletters.  The Principal controls the content of the newsletters which are used to solicit clients for the Adviser and to solicit investors in the Fund.  The model portfolios described in the Newsletters are used to manage the Adviser’s client accounts.

Fund Advertisements

The Order found that the Adviser and its Principal made materially misleading statements concerning the Fund in Newsletter articles by (i) quoting the hypothetical performance of a similarly named model portfolio as the Fund’s; (ii) attributing performance of the aforementioned model portfolio to the Principal during a period when the Principal had no involvement with the model portfolio; and (iii) quoting the Fund’s relative Morningstar ranking in a way that omitted periods for which it had poorer relative performance; (iv) using a substantially inflated Morningstar ranking for the Fund; and (v) encouraging readers to invest in the Fund as way of achieving  investment results like those of the Adviser’s similarly named model portfolio at a time when the Fund and model portfolio “held very different securities.”

The SEC also found that certain advertisements for the Funds did not comply with the standardized performance presentation requirements of Rules 482(d) and 482(g) under the Securities Act of 1933, under which advertisements containing performance data must include the average annual total return, the “length of and the last day of the period for which performance is measured,” and must be “as of the most recent practicable date.”  The Order noted that in 2008, in connection with an examination, the SEC examination staff had notified the Adviser that the Newsletters could be considered advertisements for purposes of Rule 482.  

Model Portfolio Advertisements

The SEC found that the Adviser and the Principal made several materially misleading statements concerning certain model portfolios in the Newsletters, on a related website and in the Adviser’s Twitter account.  The Newsletters and website included a chart that with (1) a statement regarding the success of the Principal’s growth model relative to the S&P 500 for a period that included several years prior to the Principal’s involvement with the model portfolio and (2) incorrect claims that the two models shown in the chart had outperformed the S&P 500 in 2009.  The SEC also found that the Principal made misleading claims regarding the performance of another model relative to the S&P 500 on the Adviser’s Twitter account because the claim related to a period that included several years prior to the time the Principal became involved with the model.

Past Specific Recommendations

The SEC found that mentions of the Adviser’s prior securities recommendations in the Newsletters and on a related website violated Rule 206(4)-1 under the Investment Advisers Act of 1940 (the “Advisers Act”) governing advertisements by registered investment advisers.  Rule 206(4)‑1(a)(2) makes it unlawful for an investment adviser to “publish, circulate, or distribute any advertisement which refers, directly or indirectly, to past specific recommendations of such investment adviser which were or would have been profitable to any person” unless certain conditions are met.  The SEC found that the Adviser did not meet the following conditions under the Rule for presenting past recommendations: (i) the Adviser did not provide a list of all recommendations by the Adviser within the past year with the name of the security and market prices, and (ii) the mentions of past recommendations were not accompanied by a legend stating: “it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.”  The SEC cited examples of mentions by the Adviser of successful past specific recommendations that were misleading because the Adviser failed to mention unsuccessful recommendations during the preceding year.

The Order noted that in 2008, in connection with an examination, the SEC examination staff had notified the Adviser that the Newsletters could be considered advertisements for purposes of Rule 206(4)-1.

Morningstar Claims

The SEC found that claims made in the Newsletters, on related websites, and in emails to potential Fund investors regarding a Morningstar ranking for the Adviser were materially misleading because: (i) Morningstar rates mutual funds, not investment advisers; and (ii) since February 2009, the Adviser had not been, as claimed, the investment manager of a mutual fund with a Morningstar five star rating.  The Order observed that in 2012 Morningstar notified the Principal that these claims were inaccurate and unauthorized.

Inadequate Policies Governing Advertisements

The SEC found that the Adviser’s written policies and procedures were not reasonably designed or implemented to ensure that the Newsletters and other advertisements and communications provided to prospective and existing investors did not contain any false or misleading information. The Order observed that the Adviser’s policies and procedures concerning advertisements “simply parroted” Rule 206(4)-1 and were not “specifically tailored to prevent advertisements in newsletters, client correspondence, or other communications with clients (e.g., Twitter or websites) from violating the Commission’s rules for advertisements by investment advisers or mutual funds.”

Violations

The SEC found the Adviser willfully violated, and the Principal willfully violated, aided and abetted and caused the Adviser’s violations of:

• Section 17(a) of the Securities Act of 1933, which in general terms prohibits fraud and misrepresentations in the offer or sale of securities;
  
  
• Sections 206(1) and 206(2) of the Advisers Act which generally prohibit fraudulent and deceptive practices by investment advisers;
  
  
• Section 206(4) of the Advisers Act and, and Rule 206(4)-8 thereunder, which generally prohibit fraudulent and deceptive practices by investment advisers with respect to any investor or prospective investor in a pooled investment vehicle;
  
  
• Rules 206(4)‑1(a)(2) under the Advisers Act relating to past specific recommendations in advertisements by registered investment advisers; and
  
  
• Rule 206(4)-1(a)(5) under the Advisers Act, which generally prohibits false and misleading advertisements by registered investment advisers.
  
  

The SEC also found that the Adviser and the Principal violated Section 34(b) of the Investment Company Act of 1940 (the “1940 Act”), which prohibits any person from making material misstatements in any record, such as investment company advertisements, required to be kept under the 1940 Act, because Rule 34b-1 under the 1940 Act deems any advertisement that omits information specified by Rules 482(d) and 482(g) to be materially misleading.

The SEC further found that the Adviser violated Rule 206(4)-7 under the Advisers Act, which governs registered investment adviser compliance programs.

Sanctions

The Principal agreed to pay a civil penalty of $100,000.  In addition to censure and a cease-and-desist order, the Respondents agreed to (1) establish internal procedures and controls reasonably designed to ensure the accuracy of representations regarding the Adviser, the Adviser’s recommendations and the Fund and (2) engage an independent compliance consultant.  In addition, the Respondents agreed to (a) mail or email a copy of the Adviser’s Form ADV, which incorporates the SEC’s findings in the Order, to each of the Adviser’s existing advisory clients, and post the entire Order on the homepage of the Adviser’s website and (b) post prominently on the home page of each website the text of the SEC’s litigation release concerning the Order, with a hyperlink to the entire Order, and maintain the posting and hyperlink on their websites for a period of twelve months from the entry of the Order.

In determining to accept the settlement, the SEC considered certain remedial acts undertaken by the Respondents.

In the Matter of Navigator Money Management, Inc. and Mark A. Grimaldi, SEC Rel. No. 33-9521 (January 30, 2014).

The FRB issued a Notice of Proposed Rulemaking to repeal its regulation implementing the Truth in Savings Act, Regulation DD, and the regulation implementing the provisions of the Gramm-Leach Bliley Act protecting the privacy of consumer financial information, Regulation P. TISA and Regulation DD are intended to assist consumers in comparing deposit accounts offered by depository institutions by requiring disclosure of fees, the annual percentage yield, the interest rate, and other account terms. The relevant provisions of GLBA limit the circumstances in which a financial institution can disclose nonpublic personal information about a consumer to nonaffiliated third parties and require financial institutions to provide certain privacy notices to their customers who are consumers. The Dodd-Frank Act transferred rulemaking authority for Regulation DD and Regulation P from the FRB to the CFPB, and in December 2011, the CFPB issued interim final rules establishing its own Regulation DD and Regulation P that were substantially identical to the FRB’s regulations. Of note, under the Dodd-Frank Act, the FRB retained authority to issue regulations implementing the Truth in Savings Act for certain motor vehicle dealers. However, the FRB “is not aware” of any motor vehicle dealers that engage in activities subject to TISA. Comments to repeal Regulation P must be received by April 15, 2014.

The FRB also issued a Notice of Proposed Rulemaking to amend its Identity Theft Red Flags Rule, which implements the provisions of the Fair Credit Reporting Act that require, among other things, each financial institution and creditor that holds any consumer account or other account for which there is a reasonably foreseeable risk of identity theft, to develop and implement an identity theft prevention program in connection with new and existing accounts. The proposed rulemaking follows the enactment of the Red Flag Program Clarification Act of 2010, which added the definition of “creditor” that was specific to the Identity Theft Red Flags Rule. The Act narrowed the definition of “creditor” and excluded from the definition, creditors that advance funds on behalf of a person for expenses incidental to a service provided by the creditor to that person. The proposed rule would provide that “creditor” has the same meaning as in the Act.

The National Futures Association (the “NFA”) issued Notice I-14-06 providing guidance to its members regarding their Bylaw 1101 obligation to determine the CFTC registration and NFA membership status of persons with whom they engage in certain transactions to the extent those persons have previously filed a notice of exemption or exclusion from CPO or CTA registration under certain CFTC regulations.  Such persons are subject to a March 3, 2014 deadline to reaffirm their notices of exemption/exclusion (as discussed in the December 10, 2013 Financial Services Alert).  The Notice addresses how an NFA member may comply with its Bylaw 1101 obligation with respect to CPOs or CTAs who have previously filed a notice of exemption/ exclusion but have not yet completed the affirmation process.  Specifically, the Notice provides that NFA members that take reasonable steps to determine the registration and membership status of such CPOs or CTAs in accordance with the guidance provided in the Notice will not be in violation of NFA Bylaw 1101 (or a similar rule pertaining to forex transactions) if they transact customer business between January 1 through March 31, 2014 with a previously exempt CPO or CTA that fails to either (a) become registered and an NFA member, (b) file a notice affirming its exemption/exclusion, or (c) provide a written representation as to why the person is not required to register or file the notice affirming the exemption/exclusion (in each case, an “Outstanding Affirmant”). 

The Notice instructs NFA members to promptly contact each Outstanding Affirmant to determine whether the person intends to file a notice affirming the applicable exemption/exclusion.  The Notice directs members to consult information being made available by the NFA to assist in their Bylaw 1101 due diligence, specifically (i) information on the NFA's BASIC System and (ii) a spreadsheet, which is updated nightly, that includes a list of all persons that have exemptions on file with the NFA that must be affirmed on an annual basis.  The Notice specifies procedures to be followed if a member learns that an Outstanding Affirmant does not intend to file a notice affirming its exemption/exclusion, or if it does not actually file the notice affirming the exemption/exclusion by March 3, 2014, which procedures may require the member to put a plan in place to cease transacting customer business with that person.

The Office of the Comptroller of the Currency (the “OCC”) issued an update to its Mortgage Banking booklet of the Comptroller’s Handbook, which was last updated in March 1996.  The Mortgage Banking booklet generally provides guidance for bank examiners and bankers regarding mortgage banking activities.  The updated Mortgage Banking booklet, among other things, addresses recent amendments to Regulation X and Regulation Z issued by the Consumer Financial Protection Bureau (the “CFPB”) that became effective in January 2014.  According to the OCC, the CFPB’s rulemaking is ongoing and bankers should ensure the standards they follow are current.  The Mortgage Banking booklet also makes changes to mortgage servicing rights to “incorporate recent lessons learned and regulatory changes.”  The OCC noted that strong oversight programs are required where critical business processes and technology are outsourced and warned that there will be increased costs associated with mortgage servicing rights because of the need for services to have “more robust” foreclosure policies and procedures, staffing, management of third-party service providers, and compliance with law, among other things.

As a result of the update to the Mortgage Banking booklet, the OCC rescinded or replaced: its March 1996 issue and the March 1998 examination procedures, Section 750 of the November 2008 OTS Examination Handbook, and OCC Bulletin 2011-29, Foreclosure Management: Supervisory Guidance.