In a December 16, 2014 letter responding to inquiries from the U.S. House of Representatives Committee on Financial Services, SEC Chair Mary Jo White described the SEC’s continued effort to increase examination coverage of investment advisers using existing resources. Among the initiatives to increase examination coverage described by Chair White were: (1) creating an Office of Risk Analysis and Surveillance within the SEC’s Office of Compliance Inspections (“OCIE”) which is responsible for systematically reviewing a variety of information (including regulatory filings, past examination reports, and information in publicly available databases) on every registered investment adviser to refine firm risk profiles and to better identify potential examination candidates for on-the-ground examinations; (2) recruiting industry experts to enhance OCIE’s ability to identify issues of particular vulnerability, conduct more focused exams, and train staff in areas such as derivatives, valuation, hedge funds, private equity, and quantitative analysis; (3) enhancing its use of advanced quantitative techniques to enable staff to more quickly and systematically analyze large amounts of data to detect potential misconduct, and (4) launching an examination initiative directed at non-private fund investment advisers that have been registered for at least three years and have never been examined. In the response, Chair White also responded to specific questions from the Committee noting that the number of investment adviser examinations conducted in 2014 increased by 20% over the prior year with relatively stable resources. Chair White also discussed the allocation of resources between broker-dealer and investment adviser examinations stating that significantly reallocating examination resources from coverage of broker-dealers to the investment adviser program would not be advisable given the demonstrated need to maintain existing coverage of broker-dealers. In addition, Chair White discussed efforts by the SEC to supplement the investment adviser examination program, noting that she has asked SEC staff to conduct a current evaluation of whether requiring investment advisers to undergo a third party compliance review may be appropriate.
Litigation & Enforcement
The SEC issued an order fining and suspending two former executives of State Street Global Advisors for violations of Section 17(a)(1) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5 resulting from misrepresentations of material facts made in connection with offering and selling an unregistered fixed income fund. The SEC’s decision reverses a 2011 decision of an administrative law judge finding that neither of the executives was responsible for, or had ultimate authority over, the allegedly false and materially misleading documents at issue. In issuing the decision the SEC noted ambiguities in the interpretation of Section 10(b) under the Exchange Act, Rule 10b-5 thereunder, and Section 17(a) under the Securities Act by the courts and provided a detailed description of its own interpretation of the provisions. The SEC found that one of the executives violated each of Exchange Act Rule 10b-5(a), (b) and (c), as well as Section 17(a)(1), by using on a number of occasions a typical presentation slide representing that only 55% of the fixed income fund’s assets would be invested in asset-backed securities when the actual amount invested in ABS was much greater. With respect to the second executive, the SEC found that the executive acted negligently in approving certain misleading communications in violation of Section 17(a)(3) under the Securities Act. (In re John P. Flannery and James D. Hopkins, Securities Act of 1933 Release No. 73840, December 15, 2014).
The SEC announced the settlement of administrative proceedings against a registered investment adviser over the SEC’s findings that the adviser was at least reckless in using materially inflated, hypothetical and back-tested performance data in marketing a suite of index products. The SEC found that during the period between September 2008 and September 2013 the adviser advertised on its website and in materials sent to clients and prospective investors that the index product had a successful 7 year track record of actual performance for the period between 2001 and 2008; however, the algorithm upon which the index product was based was not created until 2008 and the performance data presented was hypothetical. Moreover, the SEC found that the hypothetical performance was substantially inflated due to an error in applying the algorithm to historical data. In addition to agreeing to pay $30 million in disgorgement and a $5 million civil penalty, the adviser admitted to certain findings of fact in the settlement order, acknowledged that its conduct violated the federal securities laws, and agreed to certain undertakings as set forth in the settlement order. The SEC has separately filed a complaint in Federal court charging the co-founder and former Chief Executive Officer of the adviser with making false and misleading statements to investors as the public face of the adviser. (In re F-Squared Investments, Inc., Investment Advisers Act of 1940 Release No. 3988, December 22, 2014).
W. Kyle Tayman of Goodwin’s Consumer Financial Services Litigation practice wrote an article in American Banker on the recent uptick in actions by state regulators against banks and consumer finance companies for violations of Dodd-Frank’s prohibition of unfair, deceptive, or abusive acts or practices (“UDAAP”). In the last 16 months, the attorneys general of New Mexico, Illinois, Mississippi, Connecticut and Florida, as well as New York’s Department of Financial Services, have used their Dodd-Frank authority to assert civil claims alleging violations of the UDAAP provision and other federal regulations in at least 12 different actions.