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SEC Releases FY 2017 Enforcement Results: Maintaining Focus on Individual Accountability and Investment Advisers

Last night, the SEC announced its enforcement results for the Fiscal Year 2017, accompanied by a report from the Co-Directors of its Division of Enforcement.  While the total number of actions was down slightly from 2016, the percentage of those cases involving investment advisers or investment companies – 18% – remained consistent, and amounted to over 80 cases. Similarly, insider trading cases remained about 9% of the actions filed.  The Annual Report specifically highlighted cases where large investment advisers allegedly charged undisclosed or inappropriate fees to clients, focusing on the fiduciary duties advisers owe to clients.  The SEC also noted a case it settled with a large fund adviser, alleging misleading performance marketing and valuation concerns. As we have previously noted, we expect continued SEC attention in the unicorn and startup field relating to valuation and performance during FY 2018.

The results indicate that individual accountability is front and center for the agency’s enforcement staff. With 73% of the Commission’s standalone actions including charges against individuals, Co-Directors of the Enforcement Division asserted that “pursuing individuals has continued to be the rule, not the exception.” Further, the SEC has highlighted its work protecting retail or “Main Street” investors. Based on our interactions with senior SEC staff, this focus on protecting Main Street extends to funds that manage pension and retirement fund investments.

A new development at the end of FY 2017 was the creation of the specialized Cyber Unit, focusing on computer hacking, distributed ledger technology and other cyber-related threats.  Fund managers with exposure to ICOs or distributed ledger technology should prepare themselves—those issuers may face increasing regulatory scrutiny which might impact the value of those investments. For example, the SEC just recently obtained an asset freeze in a case involving allegedly fraudulent ICOs. In addition, the use of alternative data sources is likely to be a focus, particularly in situations where the Enforcement Division suspects that potential material nonpublic information is being used or shared.

Yearly data from 2014 through 2017 is summarized in the table below:

Fiscal Year 2014 2015 2016 2017
Independent/Standalone Actions 413 507 548 446
Follow-on Administrative Proceedings (i.e., SEC Proceedings initiated following conviction or injunction in District Court) 232 168 195 196
Delinquent Filings 110 132 125 112
Total Actions 755 807 868 754
Disgorgement and Penalties Ordered $4.16 billion $4.19 billion $4.08 billion $3.79 billion

For more insights into the SEC’s focus over the past year, please see our prior posts:

U.S. House Bill Aims to Curtail SEC Staff’s Ability to Obtain Algorithmic Trading Source Code

On October 4, 2017, U.S. Representative Sean P. Duffy [R-WI-7] introduced U.S. House of Representatives Bill H.R.3948 entitled the “Protection of Source Code Act.”

If enacted, the Bill would amend the Securities Act, the Securities Exchange Act, the Investment Company Act and the Investment Advisers Act to prohibit the SEC staff from obtaining algorithmic trading source code without a subpoena. This would prevent the SEC staff from obtaining source code through OCIE exam requests or during the early stages of an investigation before the staff has obtained authority to issue subpoenas. Continue Reading

Pay-to-Play – SEC Expands Scope of Rule to CABs

The SEC’s pay-to-play rule has given advisers reason to worry about potential foot faults since its adoption. As we have noted in prior posts, the rule is filled with landmines and is therefore difficult to navigate.  As was evident from the SEC’s announcement of a series of settlements of alleged pay-to-play violations in early 2017, even a small contribution without any intent to influence an election or an official can run afoul of the rule and put two years of fees and carry at risk.

Last week, the SEC issued an order that will expand the scope of the pay-to-play rule.  The SEC approved a FINRA proposal to extend the self-regulatory organization’s Rules 2030 and 4580 (its pay-to-play and associated recordkeeping rules) to a recently established category of FINRA-registered firms known as capital acquisition brokers, or CABs.

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Veil-Piercing Under California Law – Heightened Risks for Fund Managers

We recently posted about the risks associated with veil-piercing claims and the ways in which fund managers can protect themselves from exposure to these claims. Our first post on veil-piercing focused on Delaware standards, while this post discusses California law.

California law differs in several important respects from Delaware law on this topic. If a company is subject to suit in California, there are increased risks even if the company is incorporated elsewhere.  Courts may assert that California law should apply when the plaintiff is a California resident or when the company operates in California.

And where California law applies, courts may aggressively set aside corporate distinctions, leading to unanticipated results. Continue Reading

SEC Flags the Top Six Advertising Rule Deficiencies for Investment Advisers

The SEC staff recently published an alert highlighting the most common deficiencies seen in investment advisers’ marketing materials.  Based on its recent examinations and initiatives, the Office of Compliance Inspections and Examinations (OCIE) issued its risk alert to highlight compliance issues relating to Rule 206(4)-1 (the “Advertising Rule”).  Here are the top six:

  1. Misleading Performance Results.
  2. Misleading One-on-One Presentations.
  3. Misleading Claim of Compliance with Voluntary Performance Standards.
  4. Cherry-Picked Profitable Stock Selections.
  5. Misleading Selection of Investment Recommendations.
  6. Lack of Adequate Compliance Policies and Procedures.

Earlier this year, we wrote that performance marketing was one of the top 10 regulatory risks for private funds.  And after an OCIE risk alert, we often expect to see an uptick in related enforcement activity.  At minimum, OCIE is putting the industry on notice that it will scrutinize managers’ advertising and marketing materials.

For additional guidance, please read our full client alert on this topic.

Veil Piercing/Alter Ego Determinations – How Fund Managers Can Protect Themselves

A veil piercing claim can be a worst-case scenario for a private fund manager dealing with a struggling portfolio company investment – the company fails, and ensuing legal claims are brought not only against the portfolio company, but also against the fund and its GPs. How can fund managers manage that risk?

Limited liability is a hallmark of the corporate structure. Yet the legal doctrines of veil piercing and alter ego permit courts to “pierce” or bypass the corporate structure in order to hold shareholders and directors personally liable for a corporation’s actions or debts.  These doctrines have important implications in the context of a fund that owns large stakes in portfolio companies. Continue Reading

Snap Judgment: Unicorns Under Pressure and Addressing Risks of Private Lawsuits

The recent IPOs of Snap, Inc. and Blue Apron indicate that while the IPO pipeline continues to flow, there may be a cautionary tale for “unicorns” – venture-backed companies with estimated valuations in excess of $1 billion.

After Snap went public in March, it posted a $2.2 billion loss in its first quarter, yielding a 20% same-day drop in stock price that erased much of the company’s gains since its IPO. A snapshot of Snap’s stock price shows the obvious risks faced by late-stage investors in unicorns.  High valuations are not a guarantee of continued success, particularly where historical performance and profitability are lacking.  Although one commentator recently asked: “Are Blue Apron and Snap the worst IPOs ever?”, there is plenty of time for those stock prices to recover, especially in the months after their insider lockup periods expire.

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