By Chadbourne & Parke LLP’s Fund Formation and Investment Management Group
During 2016, the Securities and Exchange Commission (the “SEC”) has been active both in pursuing enforcement actions and releasing guidance updates on its various rules and initiatives. The following summary highlights recent updates regarding:
- SEC Proposal Shortens Settlement Cycle from Three Business Days to Two;
- SEC Adopts Rules to Provide More Effective Data Collection, Enhance Investor Protection and Permit Swing Pricing;
- SEC Charges Private Equity Fund Advisers with Disclosure and Supervisory Failures;
- SEC Fines Private Equity Adviser for Fee Overcharges;
- SEC Enforcement Sweep Reveals Numerous Violations of the Advertising Rule Under the Investment Advisers Act of 1940;
- SEC Enforcement Actions Continue to Focus on Insider Trading;
- SEC Charges Hedge Fund Manager for Violating Foreign Corrupt Practices Act;
- SEC Charges Bank with Conducting Unregistered U.S. Cross-Border Business;
- Enforcement Results for SEC FY 2016;
- SEC’s Office of Compliance Inspections and Examinations Provides Details Relating to the National Exam Program; and
- OCIE Publishes Risk Alert Relating to Examinations of Whistleblower Rule Compliance.
SEC Proposal Shortens Settlement Cycle from Three Business Days to Two
On September 28, 2016, the SEC proposed an amendment to Rule 15c6-1(a) under the Securities Exchange Act of 1934, as amended (the “Securities Exchange Act”) to shorten the standard settlement cycle for most broker-dealer securities transactions from three business days after the trade date (T+3) to two business days after the trade date (T+2), subject to certain exceptions. The proposed amendment is designed to reduce risks that arise from the value and number of unsettled securities transactions prior to the completion of settlement, including credit, market and liquidity risks directly faced by U.S. market participants, which in turn could reduce systemic risk for U.S. market participants.
The proposed amendment would prevent a broker-dealer from entering into a contract for the purchase or sale of a security (other than an exempted security, government security, municipal security, commercial paper, bankers’ acceptances or commercial bills) that provides for payment of funds and delivery of securities later than two business days after the trade date, unless otherwise expressly agreed to by the parties at the time of the transaction.
SEC Chair Mary Jo White stated, “[the proposal] to shorten the standard settlement cycle is an important step in the SEC’s ongoing efforts to enhance the resilience and efficiency of the U.S. clearance and settlement system… [t]he benefits of a shortened settlement cycle should extend to all investors, not just those directly involved in the trading, clearing and settling of securities transactions.” 
SEC Adopts Rules to Provide More Effective Data Collection, Enhance Investor Protection and Permit Swing Pricing
On October 13, 2016, the SEC adopted changes to improve the reporting and disclosure of information by registered investment companies and to improve liquidity risk management by open-end funds, including mutual funds and exchange-traded funds (ETFs).  SEC Chair Mary Jo White stated, “[t]hese new rules represent a sweeping change for the industry by requiring strong transparency provisions and enhanced investor protections... [f]unds will more effectively manage liquidity risk and both Commission staff and investors will receive additional and better quality information about fund holdings.”
Registered funds will be required to file a new monthly portfolio reporting form (Form N-PORT) and a new annual reporting form (Form N-CEN) that will require census-type information. Form N-PORT will require registered funds other than money market funds to provide portfolio-wide and position-level holdings data. Form N-CEN, which will replace Form N-SAR, will consolidate and enhance information reported to the SEC to reflect current information needs, such as requiring more information on exchange-traded funds and securities lending. Most funds will be required to begin filing reports on Forms N-PORT and N-CEN after June 1, 2018, while fund complexes with less than $1 billion in net assets will be required to begin filing reports on Form N-PORT after June 1, 2019.
The purpose of the liquidity risk management rules is to promote efficient liquidity risk management for mutual funds and ETFs, reducing the risk that funds will not be able to meet shareholder redemptions and mitigating potential dilution of the interests of fund shareholders. The new rules will require mutual funds and ETFs to create liquidity risk management programs that address multiple elements, including classification of the liquidity of fund portfolio investments and a highly liquid investment minimum. Most funds will be required to comply with the liquidity risk management program requirements on December 1, 2018, while fund complexes with less than $1 billion in net assets will be required to do so on June 1, 2019.
The swing pricing rule will permit mutual funds to use swing pricing, the process of adjusting a fund’s net asset value to pass on to purchasing or redeeming shareholders’ costs associated with their trading activity. The SEC is delaying the effective date of the amendments that will permit funds to use swing pricing. The final amendments, if adopted, will become effective 24 months after publication in the Federal Register.
SEC Charges Private Equity Fund Advisers with Disclosure and Supervisory Failures
On August 23, 2016, the SEC announced that four affiliated private equity fund advisers had agreed to a $52.7 million settlement for misleading fund investors about monitoring fees and a loan agreement, and failing to supervise a senior partner who charged personal expenses to the funds.
An SEC investigation found that the advisers entered into certain monitoring agreements to provide consulting and advisory services to portfolio companies that were owned by the funds. Between December 2011 and May 2015, the adviser terminated certain of these portfolio company monitoring agreements and accelerated the payment of future monitoring fees provided for in the agreements. Notably, although the advisers disclosed that they may receive monitoring fees from portfolio companies held by the funds they advised, and disclosed the amount of monitoring fees that had been accelerated following the acceleration, the SEC found that the advisers failed to disclose this conflict of interest to its funds and its funds’ limited partners prior to their commitment of capital. As the recipient of the accelerated monitoring fees, the advisers could not effectively consent to this practice on behalf of the funds they advised.
The SEC also found that the advisers failed to disclose certain information about an affiliated general partner that entered into a loan agreement to borrow $19 million from five of its funds, which was equal to the amount of carried interest then due to the general partner from those funds. The loan had the effect of deferring taxes on carried interest due to the general partner. While the loan agreement obligated the general partner to pay interest to the funds, and the funds’ financial statements disclosed that interest was accruing as an asset of the funds, the interest was instead ultimately allocated solely to the general partner, which the SEC found made the disclosures in the funds’ financial statements misleading.
Additionally, the SEC found that a former senior partner improperly charged personal items and services to the funds and their portfolio companies. Although the partner’s improper charges were discovered twice, the advisers took no further remedial or disciplinary steps on either occasion until a firm-wide expense review eventually revealed even more personal expenses the partner improperly charged to fund clients, leading to the partner’s separation from the firm.
Finally, the SEC found that the advisers failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act arising from the undisclosed receipt of accelerated monitoring fees and failed to implement policies and procedures concerning employees’ reimbursement of expenses. 
SEC Fines Private Equity Adviser for Fee Overcharges
On August 24, 2016, the SEC fined a private equity adviser for failure to disclose its fee allocation practices to certain private equity funds it advised and their investors, resulting in the funds’ paying higher management fees between 2001 and 2011. Although the funds’ governing documents provided that the quarterly management fees payable by the funds to the adviser would be reduced by an amount equal to 50% (or 80%, depending on the particular fund’s limited partnership agreement) of any transaction fees received by the adviser from the portfolio companies to the funds in order to offset the quarterly management fees payable by the funds, the documents did not disclose how transaction fees would be allocated when multiple funds and other co-investors were invested in the same portfolio company.
The SEC found that, between 2001 and 2011, the adviser adopted a transaction fee allocation methodology that resulted in the adviser retaining a significant amount of the transaction fees for itself rather than allocating them to the funds for the purpose of offsetting the management fee. As a result, the adviser retained for itself that portion of the transaction fees that was based upon co-investors’ relative ownership of the portfolio company, without subjecting such fees to any management fee offsets. The adviser did not disclose to the funds and to the funds’ limited partners that it would allocate transaction fees according to this allocation methodology, and that the ambiguous provisions in the relevant limited partnership agreements were construed in the adviser’s favor rather than in the funds’ favor. The adviser received approximately $10.4 million more in management fees using the selected methodology than if it had allocated transaction fees pro rata among the funds for management fee offset purposes during the relevant time period.
As a result of the overcharges, the SEC found that the adviser violated Section 206(2) of the Advisers Act, and the adviser reimbursed the funds approximately $10.4 million in management fees and $1.4 million in interest, and paid the SEC a civil money penalty of $2.3 million. 
SEC Enforcement Sweep Reveals Numerous Violations of the Advertising Rule Under the Investment Advisers Act of 1940 (the “Advisers Act”)
In August 2016, the SEC announced the results of an enforcement sweep against 13 investment advisory firms that were found to have violated Section 206(4) of the Advisers Act and Rule 206(4)-1(a)(5) thereunder by publishing, circulating and distributing advertisements that contained untrue statements of material fact or that were otherwise false or misleading.
According to SEC orders, the 13 investment advisory firms accepted and negligently relied on claims made by a separate advisory firm (F-Squared Investments) that its ETF investment strategy had outperformed the S&P Index for several years. In recommending investments in such strategy to their own clients, the firms repeated certain F-Squared claims without obtaining sufficient documentation to substantiate the information being advertised. In turn, F-Squared claims were based only on back-tested performance (and not any historical track record) that turned out to be substantially inflated.
The SEC also noted that the firms violated Section 204(a) of the Advisers Act and Rule 204-2(a)(16) thereunder by, among other things, failing to make and keep true, accurate and current various books and records necessary to form the basis for or demonstrate the calculation of the performance or rate of return of any or all managed accounts or securities recommendations in any advertisement.
The SEC assessed penalties against the firms ranging from $100,000 to $500,000. 
SEC Enforcement Actions Continue to Focus on Insider Trading
The SEC recently charged a hedge fund manager and his firm with insider trading based on an allegation that the manager traded on material nonpublic information he learned in confidence from a corporate executive.
The SEC alleges that the hedge fund manager used his status as a large shareholder of one of his hedge fund’s portfolio companies to gain access to company executives and obtain confidential details about the sale of a company asset, and then subsequently made profitable trades using that information.
According to the SEC’s complaint, the hedge fund manager later contacted the company executive in order to fabricate a story they questioned about his trading activity.
The SEC’s complaint further charges the hedge fund manager with failing to timely report information about holdings and transactions in securities of publicly-traded companies that he beneficially owned, alleging that he violated federal securities laws more than 40 times in doing so.
The SEC’s actions are the latest in what is a continuing regulatory focus on insider trading. 
SEC Charges Hedge Fund Manager for Violating Foreign Corrupt Practices Act
On September 29, 2016, the SEC announced that a hedge fund manager agreed to pay nearly $200 million to the SEC to settle civil charges of violating the Foreign Corrupt Practices Act (the “FCPA”). The hedge fund manager’s CEO agreed to pay nearly $2.2 million to settle SEC charges that he caused certain violations along with the CFO, who also agreed to settle the charges. The SEC detected the misconduct while examining the way financial services firms were collecting investments from sovereign wealth funds overseas. The SEC’s investigation of the hedge fund manager found that the manager used intermediaries, agents and business partners to pay bribes to high-level government officials in Africa in order to induce investments in the hedge fund manager’s funds, secure mining rights and corruptly influence government officials in several African countries.
The SEC found that the hedge fund manager’s executives ignored red flags and corruption risks and permitted illicit transactions to proceed. SEC Enforcement Division Director Andrew Ceresney stated that, “[s]enior executives cannot turn a blind eye to the acts of their employees or agents when they became aware of suspicious transactions with high-risk partners in foreign countries.” The SEC found that the hedge fund manager’s books and records did not have adequate internal controls to detect or prevent the bribes. Kara Brockmeyer, Chief of the SEC Enforcement Division’s FCPA Unit, stated that “[f]irms will be held accountable for their misconduct no matter how they might structure complex transactions or attempt to insulate themselves from the conduct of their employees or agents.”
The SEC ruled that the hedge fund manager violated the anti-bribery, books and records, and internal controls provisions of the Securities Exchange Act, and an affiliated investment adviser violated the anti-fraud provisions of the Advisers Act. 
SEC Charges Bank with Conducting Unregistered U.S. Cross-Border Business
On October 18, 2016, the SEC announced that an Israeli-based bank had agreed to pay a penalty and admit wrongdoing to settle charges that it provided investment advice and induced securities transactions for U.S. customers for more than a decade without registering as an investment adviser or broker-dealer as required under U.S. securities laws. According to the SEC order, from 2002 through 2013, the bank held securities assets for U.S. customers with an aggregate peak value of approximately $537 million without registering as a broker-dealer. Among other actions, certain of the bank’s relationship managers solicited, established and maintained brokerage accounts for certain U.S. customers; accepted and executed orders for securities transactions; handled certain U.S. customers’ funds and securities; and provided account statements and other account information. For these and other services provided to U.S. clients, the bank received compensation related to the securities transactions. Starting in 2008, the bank took certain measures to manage and mitigate the risk that such services might be provided to U.S. customers, including issuing internal policies aimed at complying with U.S. securities laws, but did not exit the vast majority of U.S. customer securities accounts that had been serviced in violation of U.S. securities laws until 2011.
In addition to the broker-dealer activities described above, the SEC also found that the bank provided investment advice to U.S. clients using U.S. jurisdictional means and received compensation related to the provision of these advisory services without registering with the SEC as an investment adviser. From 2002 through 2009, at least 11 relationship managers traveled to the U.S. on a minimum of 65 occasions to meet with existing or prospective U.S. customers and clients to provide investment advice or solicit securities transactions, and engaged in at least 245 individual meetings with both existing and potential customers and clients.
Despite the bank’s efforts beginning in 2008 to address the U.S. cross-border securities business, prohibit relationship manager travel to the U.S. and prohibit direct communications with U.S. customers and clients, the SEC found that the bank had willfully violated Section 15(a) of the Securities Exchange Act and Section 203(a) of the Advisers Act and were ordered to pay remaining disgorgement of $65,700 (the bank had previously disgorged $3.3 million of profits in a deferred prosecution agreement with the U.S. Department of Justice in 2014) and a penalty of $1.6 million. 
Enforcement Results for SEC FY 2016
The SEC recently announced that in FY 2016, the SEC filed 868 enforcement actions covering a wide range of misconduct, including a record 548 standalone or independent enforcement actions. The new record high for SEC enforcement actions included the most ever cases involving investment advisers or investment companies (160) and the most ever independent or standalone cases involving investment advisers or investment companies (98). The SEC obtained judgments and orders totaling more than $4 billion in disgorgement and penalties.
The SEC’s enforcement actions included the following topics: 
Combating Financial Fraud and Enhancing Issuer Disclosure. The SEC filed a number of actions involving significant financial fraud and issuer disclosure matters, including actions against companies and executives.
Holding Gatekeepers Accountable. The SEC held attorneys, accountants and other gatekeepers accountable for failing to comply with professional standards and sanctioned firms for such matters as ignoring red flags and fraud risks while conducting audits, violating independence rules, improperly evaluating the severity of internal control deficiencies and offering EB-5 investments while not registered to act as brokers.
Ensuring Fairness Among Market Participants. The SEC sanctioned firms for such matters as violating the federal securities laws while operating alternative trading systems, violating the market access rule (which requires firms to have adequate risk controls in place before providing customers with access to the market) and failure to adopt written policies and procedures reasonably designed to protect customer records and information.
Rooting Out Insider Trading Schemes through Innovative Uses of Data and Analytics. The SEC used data and analytical tools to charge parties with such matters as trading on the basis of inside information.
Uncovering Misconduct by Investment Advisers and Investment Companies. The SEC filed actions charging advisers with such matters as hiding financial conditions of an enterprise while raising millions of dollars from investors, steering mutual fund clients towards more expensive share classes so the firms could collect more fees and unlawful prearranged trades known as “parking” that favored certain clients over others.
Fighting Market Manipulation and Microcap Fraud. The SEC used trade suspensions to combat market manipulation and microcap fraud threats to investors, obtained a court order freezing the profits of a foreign trader who allegedly manipulated firm stock through a false EDGAR filing and sanctioned traders for fraudulent trading schemes involving the mismarking of option orders to obtain execution priority and avoid transaction fees charged by options exchanges and “spoofing” to generate liquidity rebates from an options exchange.
Standing Up for Whistleblowers. The program awarded 13 whistleblowers with total awards of approximately $57 million in FY 2016. The SEC also brought a first-ever stand-alone action for retaliation against a whistleblower and brought an action for violating Rule 21F-17 of the Securities Exchange Act, which prohibits the use of confidentiality agreements or other actions to impede a whistleblower from communicating with the SEC.
SEC’s Office of Compliance Inspections and Examinations (“OCIE”) Provides Details Relating to the National Exam Program
On October 17, 2016, Marc Wyatt, Director of OCIE, gave the keynote address to the National Society of Compliance Professionals 2016 National Conference, in which he provided details relating to OCIE’s National Exam Program. Mr. Wyatt referred to OCIE as “the eyes and the ears,” and stated that OCIE is important in “(1) improving compliance, (2) preventing fraud, (3) monitoring risk, and (4) informing policy,” areas that Mr. Wyatt referred to as OCIE’s “Four Pillars.” Mr Wyatt further stated that he views CCOs and other compliance personnel as fellow OCIE stakeholders who share a mutual interest in promoting compliance.
A significant portion of Mr. Wyatt’s speech detailed the way in which OCIE was allocating its regulatory resources based on its risk-based approach to conducting examinations. In particular, Mr. Wyatt specified how OCIE has bolstered staffing in the investment adviser/investment company examination program by roughly 20%. Mr. Wyatt further stated that “[w]e want to make sure OCIE is doing our utmost to expand our reach into this key population, and I believe our recent redeployment of staff puts us in in the best position to do that.”
Finally, Mr. Wyatt detailed how OCIE is increasingly investing in technology and data analytics in order to fulfill its mission. Of particular importance to industry participants is Mr. Wyatt’s description of how OCIE is continuously “examining” all registrants, even the roughly 90% of registrants that are not undergoing traditional examinations under OCIE’s risk-based examination strategy. Specifically, Mr. Wyatt stated that investments in technology and data analytics have enabled OCIE to “… analyze data from our entire registrant population, apply various screening methodologies, and arrive at the list of firms we believe expose investors to the most significant risks.” 
OCIE Publishes Risk Alert Relating to Examinations of Whistleblower Rule Compliance
On October 24, 2016, OCIE published a Risk Alert relating to examinations of investment advisers’ and broker-dealers’ compliance with key whistleblower provisions arising out of the Dodd-Frank Act. Rule 21F-17 under the Securities Exchange Act provides that “no person may take any action to impede an individual from communicating directly with [SEC] staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement…with respect to such communications.” Recent enforcement actions have identified certain provisions of confidentiality or other agreements required by employers as contributing to violations of Rule 21F-17 because they contained language that, by itself or under the circumstances in which the agreements were used, impeded employees and former employees from communicating with the SEC concerning possible securities law violations. Remedial actions taken in recent enforcement actions have included (i) revising documents on a go-forward basis; (ii) providing general notice to employees, or notice to employees who signed restrictive agreements, of their right to contact the SEC or other authorities; and (iii) contacting former employees who signed severance agreements to inform them that the company does not prohibit them from communicating with the SEC or seeking a whistleblower award.
The Risk Alert states that in examinations where OCIE includes a review of registrants’ compliance with Rule 21F-17, OCIE is analyzing a variety of documents, including compliance manuals, codes of ethics, employment agreements and severance agreements. In such a review, OCIE assesses whether these documents contain provisions similar to those in agreements that the SEC has found to violate Rule 21F-17, including provisions that “purport to limit the types of information that an employee may convey to the [SEC] or other authorities…and require departing employees to waive their rights to any individual monetary recovery in connection with reporting information to the government.” OCIE also assesses whether these documents contain other provisions that may contribute to violations of Rule 21F-17 in circumstances where their use impedes employees or former employees from communicating with the SEC, such as provisions that (i) require an employee to represent that he or she has not assisted in any investigation involving the registrant; (ii) prohibit any and all disclosures of confidential information, without any exception for voluntary communications with the SEC concerning possible securities laws violations; (iii) require an employee to notify and/or obtain consent from the registrant prior to disclosing confidential information, without any exception for voluntary communications with the SEC concerning possible securities laws violations; or (iv) purport to permit disclosures of confidential information only as required by law, without any exception for voluntary communications with the SEC concerning possible securities laws violations.
Registered investment advisers and broker-dealers are encouraged to consider the issues identified in the Risk Alert to evaluate whether their compliance manuals, codes of ethics, employment agreements, severance agreements and other documents contain language that may be inconsistent with Rule 21F-17. 
 See SEC Proposes Rule Amendment to Expedite Process for Settling Securities Transactions (Sept. 28, 2016), available at https://www.sec.gov/news/pressrelease/2016-200.html.
 See SEC Adopts Rules to Modernize Information Reported by Funds, Require Liquidity Risk Management Programs, and Permit Swing Pricing (Oct. 13, 2016), available at https://www.sec.gov/news/pressrelease/2016-215.html.
 See In the Matter of Apollo Management V, L.P., Apollo Management VI, L.P., Apollo Management VII, L.P. and Apollo Commodities Management, L.P., Investment Advisers Act of 1940, Release No. 4493 (Aug. 23, 2016), available at https://www.sec.gov/litigation/admin/2016/ia-4493.pdf.
 See In the Matter of WL Ross & Co. LLC, Investment Advisers Act of 1940, Release No. 4494 (Aug. 24, 2016), available at https://www.sec.gov/litigation/admin/2016/ia-4494.pdf.
 See SEC Press Release: Investment Advisers Paying Penalties for Advertising False Performance Claims (Aug. 25, 2016), available at https://www.sec.gov/news/pressrelease/2016-167.html.
 See Securities and Exchange Commission v. Leon G. Cooperman and Omega Advisors, Inc. (Sept. 21, 2016), available at https://www.sec.gov/litigation/complaints/2016/comp-pr2016-189.pdf.
 See In the Matter of Och-Ziff Capital Management Group LLC, OZ Management LP, Daniel S. Och, and Joel M. Frank, Securities Exchange Act of 1934, Release No. 78989 (Sept. 29, 2016), available at https://www.sec.gov/litigation/admin/2016/34-78989.pdf.
 See In the Matter of Bank Leumi Le-Israel B.M., Leumi Private Bank, and Bank Leumi (Luxembourg) S.A., Securities Exchange Act of 1934, Release No. 79113 (Oct. 18, 2016), available at https://www.sec.gov/litigation/admin/2016/34-79113.pdf.
 For additional detail, please see SEC Announces Enforcement Results for FY 2016 (Oct. 11, 2016), available at https://www.sec.gov/news/pressrelease/2016-212.html
 See Transcript of Marc Wyatt, Inside the National Exam Program in 2016 (Oct. 17, 2016), available at https://www.sec.gov/news/speech/inside-the-national-exam-program-in-2016.html.
 See National Exam Program Risk Alert, Office of Compliance Inspections and Examinations, Examining Whistleblower Rule Compliance (Oct. 24, 2016), available at https://www.sec.gov/ocie/announcement/ocie-2016-risk-alert-examining-whistleblower-rule-compliance.pdf.