News of Note to Investment Managers
November 20, 2001
Over the past several months state and Federal regulators have addressed numerous topics of interest to investment managers. This Hedge Fund and Investment Managers Advisory summarizes developments in several of the most notable reports, as well as other items of note.
STATE REGULATION OF INVESTMENT ADVISERS
Are Solicitors Investment Advisor Representatives? State securities commissions have been taking steps to categorize third party solicitors working for SEC-registered investment advisers (IAs) as investment advisers representatives (IARs). Washington State has adopted a regulation explicitly including within the IAR definition solicitors who are not supervised persons of federally registered IAs. During the summer, Kansas proposed a similar rule based upon the model rules of the North American Securities Administrators Association (NASAA). The Investment Counsel Association of America (ICAA) argued against the proposal in a letter, stating that it would not protect investors, would burden solicitors with IA licensing requirements and mislead investors into thinking that solicitors are employees of IA firms.
Joseph Borg, the director of the Alabama Securities Commission and NASAA’s new president, recently opined that solicitors are often asked for their opinions and that it is doubtful that they limit themselves to solicitation activities by responding, “Sorry, I can’t answer that question.” According to Melanie Senter Lubin, Maryland’s securities commissioner and a NASAA board member, a majority of states have adopted rules that treat solicitors as IARs. Every IA firm that uses solicitors will have to consider registering them as IARs for the firm in those states in which the firm is a registered IA and in those states in which the solicitor has a place of business.
Increased State IA Examinations. Mr. Borg also recently promised stronger state oversight of the investment adviser industry, noting that “the growing potential for fraud by small investment advisers should concern us all.” He said that for the new year NASAA will focus on increased exams of investment advisory firms, electronic registration of advisers, and NASAA’s “uniformity project” to promote uniform state regulation. He also said he would urge state regulators to adopt the Investment Adviser Registration Depositary (IARD) to make it easier for investors to choose investment advisory firms. So far, according to NASAA, 39 states have committed to adopt the IARD, either by administrative order or through legislation.
Continuing Education for IARs. At the NASAA fall conference in San Francisco, a project group delivered a report on continuing education requirements in other financial professions. The report covered the continuing education requirements set by a variety of institutions for other financial professions, such as certified financial planners, insurance representatives and accountants. A NASAA continuing education initiative for IARs appears to be in the works.
State Enforcement Action Filed Against IA that Missed IARD Filing. The Connecticut Department of Banking has filed an enforcement action against an SEC-registered IA for missing its IARD registration deadline. Vernes Asset Management was required to notice file with the state through the IARD by checking the box next to Connecticut’s name. While Connecticut does not require its state-registered advisers to use the IARD, the SEC requires SEC-regulated IAs to notice-file with any state that requires such a filing. The firm paid a $2,000 fine and $500 for investigative costs, despite the fact that the firm brought the matter to the attention of the regulators on its own. Nevertheless, a department spokesman said the Department encourages firms to report themselves if they realize they are in violation of rules, adding, “if we find out it’s willful, any action we take is going to be stronger.”
ADVERTISING BY INVESTMENT ADVISERS
ICAA Proposal. The ICAA has proposed a major revision in the way IA advertising is regulated by SEC rule. At present, IA advertising rules are defined by a list of prohibitions. For example, IAs may not provide the names of their existing clients, quarter-end portfolio holdings, or their gross performance results. On the other hand, the ICAA argues, “banks and broker-dealers - who increasingly compete with advisers to provide advisory services - are routinely permitted to provide their customers with such information, without being deemed to commit per se fraud.” The ICAA also argues that to understand what is and what is not currently permitted requires a review of “a thicket of no-action letters and enforcement proceedings,” especially with respect to performance advertising.
The ICAA proposal would eliminate four specific prohibitions contained in Rule 206(4)-1, none of which, according to the ICAA, are inherently fraudulent and all of which suffer from other defects. The prohibition barring testimonials, including any statement of a client’s experience with the adviser, is unnecessary, ICAA claims, because “if advisers were permitted to publish testimonials, they would, as fiduciaries, be obligated to provide consumers with appropriate disclosure.” The ICAA declared outmoded the prohibition barring representations that graphs, charts, and other devices can be used to determine which securities to buy or sell or the timing of securities transactions, stating that, “we believe the Rule is based on old-fashioned skepticism of computer-based technologies that could benefit investors.” In any event, the general anti-fraud provisions of the Investment Advisers Act of 1940 would always apply.
The third prohibition the ICAA wants to eliminate is the one that bars references in advertisements to any specific past recommendations that were or would have been profitable to any person, unless all specific past recommendations of the adviser for the immediately preceding one-year period are also provided or offered. The concern that IAs would “cherry-pick” only the most profitable recommendations is already addressed by other provisions of the Advisers Act, according to the ICAA. Similarly, the ICAA wants to eliminate the ban on statements that any report, analysis, or other service will be given free or without charge, unless it is entirely free, because the general anti-fraud provisions of the Advisers Act already prohibit such conduct.
The ICAA proposes replacing the specific prohibitions mentioned above with a general anti-fraud standard that would proscribe advertisements that contain any untrue statement of a material fact or omit to state a material fact needed to “make a statement made, in light of the circumstances of its use, not misleading.” This proposal follows along the lines of the existing rule that applies to investment company advertising. Also proposed are minimum standards for performance results prepared for retail clients and a recommendation that the SEC staff issue an interpretive release that clarifies and consolidates all relevant SEC “pronouncements” and conflicting prior positions.
With respect to performance advertising standards, the ICAA proposal would distinguish between retail and institutional customers. Performance presentations to institutional clients would be subject only to the general anti-fraud standard. For this purpose, institutional clients would include all “qualified clients” as defined in Rule 205-3 under the Advisers Act. [1] Performance presentations to retail clients, however, would have to disclose: (i) the type of accounts or strategy represented; (ii) a description of how the average annual total return performance history was calculated; (iii) the average annual total returns of an appropriate securities market index; (iv) the number of clients whose accounts are included in the average annual total returns presented in the advertisement; (v) the total assets of all client accounts included in the returns advertised; and (vi) the length of, and the date of the last day in, the period used to compute the adviser’s performance history.
A similar proposal was offered by the Investment Company Institute in 1998 but the ICI has not followed up. It is uncertain whether or not the SEC is willing to take up a rule revision proposal at this time.
AIMR Compliance. Many IAs are interested in advertising the fact that they are compliant with Association for Investment Management and Research (AIMR) performance presentation standards, but are daunted by the complexity of the calculations required to demonstrate compliance. Several vendors have announced the availability of systems that will perform the calculations. Systems ranging in cost from $25,000 to $300,000 are available from CAPS Incorporated, http://www.capsinc.com, StatPro, Inc., http://www.statpro.com, and SunGard Investment Management Systems, http://www.sungardinvestment.com.
CHANGES IN SEC EXAMINATION PRACTICES
Deficiency Letters. It has been assumed that the receipt of a deficiency letter from the Securities and Exchange Commission at the conclusion of an examination meant that the firm would not face enforcement action. According to Lori Richards, director of the Office of Compliance Inspections and Examinations (OCIE), the staff recently changed its practice of not sending letters to problem firms when it refers a matter for further investigation by enforcement staffers. The SEC staff apparently wants to give firms an opportunity to remedy deficiencies noted during examinations. If, however, the staff believes that documents may be destroyed or that investors’ funds may be at risk, an enforcement referral may not be preceded by a deficiency letter. Deficiency letters will not state whether an enforcement referral is or is not contemplated. Hopefully, the deficiency letter process will be permitted to run its course before an enforcement referral is made. This would allow a firm the opportunity to act on the letter or respond to it before it is too late to prevent an enforcement referral. Deficiency letters have been known to contain errors from time to time, so this would be particularly significant if the OCIE examiners reached an incorrect conclusion.
E-Records Review. Kevin Goodman, senior special counsel at the SEC, recently told compliance conference attendees that every IA exam will have some electronic record keeping review, and in some cases a heightened review. This new focus follows the SEC’s recent upgrade of its IA e-records rules prompted by the Electronic Signatures in Global and National Commerce Act of 2000, also known as ESign, that instructed government agencies to allow e-record storage. In particular, examiners will want to cover the “high spots,” such as whether people leave their computer terminals unattended and whether passwords are extinguished for employees leaving IA firms.
Privacy Rules. Similarly, SEC-registered IAs should expect to have Regulation S-P compliance included in their staff examinations. Regulation S-P requires IAs and certain other financial institutions to adopt policies and procedures designed to insure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of customer records, and protect against unauthorized access to customer records or information that could result in substantial harm to any customer (see our August 23, 2000 Hedge Fund & Investment Managers Advisory). Gene Gohlke, OCIE associate director, recently noted that at one IA the firm’s server was located outside its firewall. Because the firm used e-mail extensively to communicate with clients, their personal information was accessible by any computer hacker with a desire to see it.
State-registered and unregistered IAs are subject to the privacy regulations of the Federal Trade Commission rather than those of the SEC. The FTC permits IAs under its jurisdiction to satisfy their obligations concerning what information they can share and the use of opt-outs under the FTC’s Privacy of Consumer Information Rule by complying with the notice provisions of Regulation S-P. The FTC recently proposed a Standards For Safeguarding Customer Information Rule addressing how companies guard information against unauthorized access. Both the Financial Planning Association and NASAA have asked the FTC to create a carve out that will also permit state-registered IAs to comply with Regulation S-P instead. A final draft is expected in several months.
Money Laundering. Mr. Gohlke also stated recently that the OCIE staff will inspect to ensure that IAs have policies and procedures in place to monitor for money laundering activity. The USA Patriot Act of 2001, which was signed into law October 26 and will become effective in May, 2002, requires all financial institutions to establish money laundering security programs and requires broker-dealers formally to file Suspicious Activity Reports, which already are required of banks under the Bank Secrecy Act.
[1] Qualified clients are those who either (i) have $750,000 under management with the IA, (ii) have a net worth of $1,500,000, (iii) are “qualified purchasers” under Section 2(a)(51)(A) of the Investment Company Act of 1940, or (iv) are “knowledgeable employees” of the IA.
In general there are five categories of qualified purchasers: (1) natural persons owning investments of at least $5 million; (2) family owned companies owning not less than $5 million in investments; (3) trusts whose trustees or equivalent decision makers and whose settlors or other asset contributors are all qualified purchasers described in clauses (1) and (2);(4) institutional investors, acting for their own accounts or for other qualified purchasers, that own and invest on a discretionary basis “investments” of at least $25 million, including employee benefit plans that are not participant-directed; and (5) certain qualified institutional buyers acting for their own accounts or for other qualified institutional buyers or qualified purchasers. Specifically excluded from the definition of qualified purchasers are (a) participant-directed employee benefit plans and (ii) any entity formed for the specific purpose of investing in a fund for qualified purchasers unless all of the entity’s beneficial owners are themselves qualified purchasers.
The term “knowledgeable employees” includes executive officers, directors, trustees, and general partners of the IA, and other persons serving in similar capacities, as well as certain other employees of the IA who participate in investment activities and have performed such functions for at least 12 months.
For additional information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.