SEC Quarterly Round-Up
Steven R. Howard
President Trump appoints a new SEC chair; and the SEC issues guidance on robo-advisers, Inadvertent Custody, and the 2017 Examination Priorities
New SEC chair appointed by President Trump
President Trump appointed high profile Wall Street lawyer, Jay Clayton, a senior corporate partner at Sullivan & Cromwell, to be the next Chairman of the SEC. Mr. Clayton is expected to receive Senate confirmation later in March 2017. Unlike the former Chairwoman Mary Jo White, who is a litigator and hailed from Debevoise, Mr. Clayton is a high level corporate transactions partner who is widely expected to reduce the number of SEC enforcement proceedings and the amount and extent of SEC financial services regulation. President Trump has two additional SEC Commissioners to appoint.
SEC issues guidance on robo-advisers
The Investment Management Division of the SEC issued guidance on robo-advisers which are investment advisers that use computer algorithms to provide online investment advisory services. The guidance offers suggestions for how robo-advisers can satisfy their disclosure, suitability and compliance obligations under the Investment Advisers Act of 1940 (the “IAA”). Robo-advisers, like all investment advisers, are subject to the anti-fraud provisions of the IAA, and in certain instances, also subject to regulatory and fiduciary requirements of the IAA. The guidance is limited in nature and emphasizes that robo-advisers may meet their regulatory requirements in a variety of ways and that not all aspects of the current guidance may apply to every type of robo-adviser. The SEC also issued guidance for investors concerning how to use robo-advisers for making investments. We can expect additional guidance from the SEC on robo-advisers as more industry participants turn to this type of investment advice delivery system.
SEC issues guidance on inadvertent custody: advisory contract versus custodial contract authority
The Investment Management Division of the SEC has issued guidance concerning when an investment adviser may inadvertently have custody of client funds or securities because of provisions in a separate custodial agreement entered into between its advisory client and a qualified custodian. Custodial agreements between a client and a custodian may grant the adviser broader access to client funds and securities than the adviser’s own agreement with the client contemplates. Depending on the wording of these agreements, an adviser may have custody and be subject to surprise audit examinations and other custody requirements, even though the adviser did not otherwise intend to have access to clients’ funds and securities. Phrases granting advisers the right “to receive money, securities and property”, or “instruct the custodian to disburse cash from a client account” create this inadvertent custody problem for unwitting advisers. To avoid this inadvertent custody problem, the SEC recommends that advisers send a letter to the custodian that limits the adviser’s authority to “delivery versus payment”, notwithstanding the wording of the custodial agreement, and to have the client and custodian provide written consent to acknowledge this clarification.
The SEC and FINRA announce their 2017 examination priorities
In 2017 the SEC will focus its examinations on
- Retail investors – protecting retail investors from product and service risks, robo-advisers and wrap fee programs.
- Senior investors and retirement investments – focusing on variable insurance products and target-date funds.
- Market-wide risks – Focusing on compliance with the SEC’s Regulation SCI and anti-money laundering rules, particularly for money market funds.
- FINRA – enhancing oversight of FINRA by inspecting its operations, regulatory programs and assessing broker-dealer examinations.
- Cybersecurity – overseeing compliance with cybersecurity compliance procedures and controls for advisers and broker-dealers.
In 2017 FINRA, the regulator for broker-dealers, will focus on
- High-risk and recidivist brokers – identifying them and reviewing their firms supervisory procedures.
- Senior investors – protecting them from purchasing speculative or complex products and micro-cap fraud schemes.
- Product suitability and concentration – assessing how brokers make customer suitability judgments and investment concentration judgments.
- Excessive and short-term trading of long-term products – evaluating how brokers monitor this trading.
- Other outside business activities and private securities transactions – evaluating how these activities may compromise a broker’s responsibilities to customers.
- Social media supervision – monitoring brokers compliance with internal policies and procedures for social media use and retention.
- Liquidity risk – reviewing brokers liquidity risk management plans.
- Financial risk management – examining specific stress scenarios for larger firms.
- Credit risk policies under FINRA Rule 4210 – assessing compliance with margin requirements for covered agency transactions.
- Municipal adviser registration – assessing proper registration by municipal advisers with the SEC and the Municipal Securities Rulemaking Board.
- Trading examinations – reviewing the adequacy of alternative trading systems’ disclosures to customers about how they operate and remediate conflicts.
- Fixed income securities surveillance program – overseeing the new TRACE reporting requirements for transactions in US Treasury securities.
In the past, the SEC and FINRA have adhered closely to their stated priorities in their examinations, and we expect that to be the case in 2017. Financial services compliance professionals should tailor their compliance programs and training to the priorities and practices described above by the SEC and FINRA.
SEC breaks new ground in the foreign distribution of US mutual funds
The SEC’s Investment Management Division has issued a no-action letter that permits for the first time a foreign feeder fund to invest in an affiliated registered US based master mutual fund. In effect, the no-action letter provides for the broader global distribution of US mutual fund products which has been historically prohibited by section 12(d) of the Investment Company Act. The no-action letter also allows the foreign feeder fund to engage in limited currency and index hedging.
The SEC no-action letter imposes the following conditions: (1) the foreign feeder manager will make its books and records available for SEC examination; (2) the foreign feeder fund must be organized in a jurisdiction that has entered into an SEC cooperation agreement; (3) the foreign feeder fund cannot sell securities to US investors; and (4) the hedging activities will only be permitted for currency and index hedging related to the master fund’s index strategy.
We can expect many major US mutual fund groups to vastly broaden the scope of their marketing efforts for their US based mutual funds.
Federal Judge finds no attorney-client privilege for independent mutual fund trustees
Author Steven R. Howard
Independent mutual fund trustees have a fiduciary duty to fund shareholders that requires them to divulge all relevant board meeting discussions
In a recent ground-breaking federal district court case, Robert Kenny v PIMCO (Western District of Washington, Case No. C14-1987-RSM), Chief District Judge Ricardo Martinez issued a court order that required the independent mutual fund trustees of the PIMCO Total Return Fund to divulge to that fund’s shareholders all of the independent trustees’ confidential deliberations concerning their PIMCO advisory contract review. In so doing, Judge Martinez applied the “fiduciary exception” to the attorney-client privilege because he found the independent trustees owed a fiduciary duty to the beneficiaries of the trust—the mutual fund shareholders. Judge Martinez held that the attorney-client privilege for independent mutual fund trustees only protects personal advice from the trustees’ lawyer, and advice concerning potential or actual litigations against them in their personal capacity.
The Kenny v PIMCO case is extraordinarily important because in effect independent trustees of mutual funds going forward should expect no protection from the attorney-client privilege, except concerning matters personal to them, such as their potential liabilities, indemnification, d&o/e&o insurance, litigations (actual and potential), and perhaps, trustee compensation. In effect, the many centuries old attorney-client privilege has been eviscerated in the context of independent mutual fund trustees.
Judge Martinez relied heavily upon a US Supreme Court case, US v Jicarillo, 564 US 162 (2011), involving a trust which he likened to the PIMCO Total Return Fund which was structured as a Massachusetts business trust. By invoking common trust case law, Judge Martinez reasoned that the mutual fund trustees have a fiduciary duty to all trust beneficiaries which in this case are the mutual fund shareholders, and concluded that withholding information from fund shareholders would be a breach of that fiduciary duty. Interestingly, some mutual funds and almost all closed-end funds are structured as corporations to which trust law does not apply. For those funds that are structured as corporations, partnerships and limited liability companies, the attorney-client privilege may still protect the deliberations of the board members who are generally directors, partners or members, not trustees.
We can expect the Kenny v PIMCO case to be aggressively used by plaintiffs’ counsel in all future section 36b cases under the Investment Company Act of 1940 that challenge allegedly excessive advisory fees that are paid to advisers of mutual funds and have been approved by independent mutual fund trustees. Going forward, the independent mutual fund trustees will have no protection from the attorney-client privilege in those section 36b litigations, unless the Kenny v PIMCO case is overturned or modified which is unlikely. Rather, we expect the eleven federal circuits to endorse the holding in the Kenny v. PIMCO case which over time will have a chilling effect on independent mutual fund trustee deliberations.
The unquiet and protracted death of the US Department of Labor’s Fiduciary Rule
Author Steven R. Howard
The effectiveness date of the DOL’s Fiduciary Rule has been delayed and we expect that the rule will not become effective under the Trump Administration
On February 3, 2017, President Trump issued a Presidential Memorandum requiring the US Department of Labor (the “DOL”) to reconsider its proposed and highly controversial Fiduciary Rule which subjects brokers to a best interests standard when brokers give investment advice to retail retirement account customers. The Memorandum directs the DOL to prepare an updated economic and legal analysis of the Fiduciary Rule to determine whether it may adversely affect the ability of Americans to obtain access to retirement information and financial advice. The Memorandum also directs the DOL to consider whether it is appropriate to revise or rescind the Rule.
On February 28, 2017, the DOL proposed a 60 day delay of the Rule’s effectiveness date—April 10—and invited a 15 day public comment period on the Rule’s delay. The DOL also provided for a 45 day comment period regarding “the examination described in the President’s Memorandum.” Interestingly, the likelihood of protracted litigation concerning the implementation of the Rule has been significantly increased by the shortened timeframes in which the DOL has to consider the merits of the delay and to undertake the economic and legal analysis required by the President’s February 3 Memorandum. The quick review by the DOL may also be hampered by the absence of an approved Secretary of the DOL. Andrew Pudzer, President Trump’s first DOL Secretary appointee, withdrew from consideration, and the US Senate has yet to review President Trump’s second DOL Secretary appointee, Alexander Acosta. While it appears that the Fiduciary Rule has been Trumped, the litigation gauntlet for the DOL Fiduciary Rule will be long.
The constitutional uncertainty of US administrative law judges
Author Steven R. Howard
The US Supreme Court will have to decide whether the SEC’s administrative law judges were constitutionally appointed to their positions.
In US federal administrative agencies there are about 1,800 administrative law judges (ALJs), many of whom may not have been constitutionally appointed to their positions. The 10th US Circuit Court of Appeals ruled in Bandimere v SEC that the Constitution’s Appointments Clause applies to the SEC’s ALJs because they exercise “significant discretion” in presiding over enforcement proceedings, therefore requiring appointment by the US President or an officer appointed by the President. SEC ALJs are not appointed by the US President, nor are they appointed by the SEC’s Commissioners who are appointed by the US President. Rather, SEC ALJs are appointed by a personnel office of the SEC. The 10th Circuit Court decision vacated the SEC’s enforcement order against David Bandimere, a Denver businessman, because the SEC ALJ who presided over his enforcement case was not duly appointed by the President or an officer appointed by the President. The Bandimere case has created a split among the federal Circuit Courts on the constitutional issue with the District of Columbia Circuit Court which held in a recent case, Lucia v SEC, that SEC ALJs are employees, not officers subject to the Appointments Clause.
The SEC has dramatically increased its use of SEC ALJs in enforcement cases instead of litigating the cases in federal district courts to resolve civil cases of securities fraud since the passage of the Dodd-Frank Act in 2010 which gave the SEC the discretion to more broadly use SEC ALJs. SEC ALJs are not required to conduct their hearings in accordance with the Federal Rules of Civil Procedure. SEC ALJs as a consequence are permitted to ignore standard rules of evidence and may admit hear say into evidence. SEC ALJs are also not required to conduct their hearings in accordance with due process protections. As the dissent in the Bandimere case pointed out, potentially thousands of administrative enforcement orders may be invalid because of the constitutionally defective appointment of ALJs in many federal administrative agencies in addition to the SEC.
On February 16, 2017, the DC Circuit Court granted a petition for an en banc rehearing of its Lucia v SEC decision which unanimously held that SEC ALJs were merely employees, not officers, and therefore not subject to the Appointments Clause. It is not clear why the DC Circuit Court granted the petition to rehear the case. In any event, either way the en banc Court decides its rehearing, a split among the federal Circuit Courts will continue to exist which will likely lead to a review of this issue by the US Supreme Court.