40 Act Blog

Alternative Mutual Fund Found to Have Violated Custody and Brokerage Rules

The SEC brought an enforcement action against Water Island Capital LLC (Water Island), in connection with investment company custody violations.  Water Island is based in New York, New York, and manages certain alternative mutual funds (the “Funds”) with approximately $3.5 billion in assets. To carry out its strategies, Water Island trades equities and derivatives including swaps.

SEC Division of Investment Managment Director is Resigning January 25, 2015

Investment Management Director to Leave the SEC

2015 Exam Priorities Issued by OCIE

The SEC’s Office of Compliance Inspections and Examinations (OCIE) announced its 2015 examination priorities. OCIE stated that the priorities reflect certain practices and products that OCIE perceives to present potentially heightened risk to investors and/or the integrity of our capital markets. OCIE conducts examinations of registered entities, including investment advisers, to promote compliance, prevent fraud, identify risk, and inform policy. It selected its 2015 examination priorities in consultation with the SEC’s five Commissioners, senior staff from the SEC’s eleven regional offices, the SEC’s policy-making and enforcement divisions, the SEC’s Investor Advocate, and other regulators.

OCIE stated that its priorities are organized around three thematic areas:   • Examining matters of importance to retail investors and investors saving for retirement, including whether the information, advice, products, and services being offered is consistent with applicable laws, rules, and regulations; • Assessing issues related to market-wide risks; and • Using its evolving ability to analyze data to identify and examine registrants that may be engaged in illegal activity, such as excessive trading and penny stock pump-and-dump schemes.

OCIE noted that investment advisers employ a variety of fee structures for the services offered to clients, including fees based on assets under management, hourly fees, performance-based fees, wrap fees, and unified fees. Where an adviser offers a variety of fee arrangements, OCIE will focus on recommendations of account types and whether they are in the best interest of the client at the inception of the arrangement and thereafter, including fees charged, services provided, and disclosures made about such relationships.

OCIE stated that it will assess whether registrants are using improper or misleading practices when recommending the movement of retirement assets from employer-sponsored defined contribution plans into other investments and accounts, especially when they pose greater risks and/or charge higher fees. It will evaluate registered entities’ recommendations or determinations to invest retirement assets into complex or structured products and higher yield securities, including whether the due diligence conducted, the disclosures made, and the suitability of the recommendations or determinations are consistent with existing legal requirements.

The release also discussed alternative investments. OCIE said that funds holding “alternative” investments, or those offering returns uncorrelated with the stock market, have experienced rapid and significant growth compared to other categories of mutual funds. OCIE will continue to assess funds offering alternative investments and using alternative investment strategies, with a particular focus on:   • leverage, liquidity, and valuation policies and practices; • factors relevant to the adequacy of the funds’ internal controls, including staffing, funding, and empowerment of boards, compliance personnel, and back-offices; and • the manner in which such funds are marketed to investors.

OCIE also discussed fixed-income investment companies. With interest rates expected to rise at some point in the future, it will review whether mutual funds with significant exposure to interest rate increases have implemented compliance policies and procedures and investment and trading controls sufficient to ensure that their funds’ disclosures are not misleading and that their investments and liquidity profiles are consistent with those disclosures.

OCIE stated that it has made significant enhancements in data analytics that enable it to efficiently and effectively analyze the data to which it has access. It will use these capabilities to focus on registrants and firms that appear to be potentially engaged in fraudulent and/or other potential illegal activity, including the following examination initiatives:   • recidivist representatives; • microcap fraud; • excessive trading; and • anti-money laundering.

OCIE concluded by noting initiatives in other areas:   • municipal advisors; • proxy services; • never-before-examined investment companies; • fees and expenses in private equity; and • transfer agents.

Click here to access the release announcing the priorities.

Deadline for Mutual Funds to Reaffirm Their CFTC Rule 4.5 Notices

A mutual fund currently relying on Rule 4.5 under the Commodity Exchange Act must reaffirm or withdraw of its existing notice by March 2, 2015. Rule 4.5 requires each mutual fund that filed a notice of exclusion under the rule to reaffirm the notice within 60 days of the calendar year end, or withdraw the exclusion. A mutual fund may be in the position to withdraw the exclusion because it is no longer engaged in the trading of commodity interests or because registration of the fund’s investment adviser as a CPO is required).

SEC Appoints New Associate Director of OCIE

The SEC named Kevin M. Kelcourse as the Associate Director of the Office of Compliance Inspections and Examinations (OCIE) in Boston, Massachusetts. He will oversee the SEC’s exam program in six New England states and supervise a staff of approximately 65 examiners, accountants and attorneys.

SEC Brings Enforcement Action for a Variety of Compliance Issues

Alan Gavornik, Nicholas Mariniello and Lee Argush, all principals of Concord Equity Group Advisors, LLC (formerly an SEC-registered investment adviser) settled charges with the SEC, which had alleged that they breached their fiduciary duty to advisory clients by failing to disclose a conflict of interest and by failing to seek to obtain best execution for their clients. Alan Gavornik was the Chief Compliance Officer of Concord.

SEC Releases Its 2014 Annual Report

The SEC release its 2014 Annual Report. SEC Chairman Mary Jo White began the report by stating that the SEC brought a record number of enforcement actions, proposed and adopted rules that strengthened the nation’s financial system and increased transparency, promoted compliance through detailed, risk-based examinations of registrants and furthered enhanced transparency through our disclosure review program.

SEC Grants First Non-Transparent ETF Exemptive Order

The SEC approved the first non-transparent actively managed exchange-traded fund to be offered by Eaton Vance. The SEC’s Division of Trading and Markets approved a request by Nasdaq to adopt a new rule governing the listing and trading of a new fund structure called the exchange-traded managed fund (ETMF). The ETMF would not be required to disclose its holdings on a daily basis. ETMFs would be listed on an exchange like an ETF and trade using a new trading protocol called “NAV-based trading.” The SEC’s Division of Investment Management also issued a notice stating its intent to grant Eaton Vance exemptive relief from certain provisions of the 1940 Act to permit the offering of ETMFs. These two divisions of the SEC must grant permission to fund managers to create non-transparent ETFs, as well as approve an exchange's proposed rule change to list such funds.

Hedge Fund Adviser Sanctioned for Delivering Audited Financial Statements After the Custody Rule Deadline

The SEC brought an enforcement action against Sands Brothers Asset Management, LLC (SBAM), Steven Sands, Martin Sands and Christopher Kelly failed to timely distribute audited financial statements to the investors of hedge funds managed by SBAM in violation of Rule 206(4)-2 under Section 206(4) of the Advisers Act – the “custody rule”. In 2010, SBAM was the subject of a settled administrative proceeding, In re Sands Brothers Asset Management LLC, et al., Release No. 3099 (Oct. 22, 2010), by which the SEC censured SBAM, ordered it to cease and desist from violating the Advisers Act, including Rule 206(4)–2, and ordered it to pay a $60,000 civil money penalty. The SEC also found that they violated the 2010 order by failing to implement any procedures or safeguards to ensure compliance with that Rule.

SEC Division of Investment Manager Director Speaks on Complex Products

Norm Champ, the SEC’s Director of the Division of Investment Management, spoke at the SIFMA Complex Products Forum in New York on specialized products. He began by noting that his Division views the exemptive application process as the laboratory where it examines new ideas from market participants, most recently including a proposed non-transparent ETF structure. In addition, he stated that the Division’s role of reviewing disclosure and fund financial reporting also affords its staff the opportunity to identify and monitor industry-wide risks. For example, last year, the disclosure review staff noticed an increase in the number of funds using the word “protected” in their fund names. In response, the staff raised concerns because the fund’s name suggests safety or protection from loss.