advisers act regulatory series - eversheds sutherland · 2020-06-04 · preparing for your firm’s...

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Fourth Quarter UpdateAdvisers Act Regulatory Series

December 6, 2018

Clifford Kirsch, Michael Koffler, Issa Hanna, Ben Marzouk and Bria Adams

Eversheds Sutherland

Advisers Act Regulatory Series

SpeakersFourth Quarter Update

Clifford KirschNew York, NY+1 212 389 [email protected]

Michael KofflerNew York, NY+1 212 389 [email protected]

Ben MarzoukWashington DC+1 202 383 [email protected]

Bria AdamsWashington DC+1 202 383 [email protected]

Issa HannaNew York, NY+1 212 389 [email protected]


Today’s Discussion:


─ OCIE’s Risk Alert on the Cash Solicitation Rule

─ Preparing for Your Firm’s 2019 Form ADV Update

─ Update on Federal and State Fiduciary Initiatives

─ GIPS 2020

─ Exam and Enforcement Developments: Reg S-ID and Reg S-P Enforcement

─ A Look Ahead: The 2019 Regulatory Agenda

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OCIE Risk Alert: Investment Adviser Compliance Issues Related to the Cash Solicitation Rule


─ Rule 206(4)-3 (the Cash Solicitation Rule) prohibits the payment of a cash fee, directly or indirectly, to any person who solicits clients for the adviser unless the adviser and solicitor comply with conditions of the rule

─ The term “solicitor” is defined as “any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser”

─ The term “client” also includes any prospective client─ Requirements applicable to all solicitation arrangements:

• The adviser must be registered with the SEC • The solicitor must not be subject to disqualifications noted in

Section 203 of the Advisers Act• The solicitation fee must be paid pursuant to a written

solicitation agreement to which the adviser is a party

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─ Solicitors fall into one of three categories under the rule:• Option #1: Solicitors who provide impersonal advisory services only

• Impersonal advisory services are defined under the Advisers Act as “investment advisory services provided solely by means of (i) written materials or oral statements which do not purport to meet the objectives or needs of the specific client; (ii) statistical information containing no expressions of opinions as to the investment merits of particular securities; or (iii) any combination of the foregoing services”

• Option #2: Solicitors who are affiliated with the adviser (i.e., a partner, officer, director or employee of the adviser or a partner, officer, director or employee of a person which controls, is controlled by, or is under common control with the adviser)

• The status of the solicitor as a partner, officer, director or employee of the adviser or other person, and any affiliation between the adviser and such other person, must be disclosed to the client at the time of the solicitation or referral;

• Option #3: Solicitors who are third parties (i.e., not Option #1 or #2)

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─ Third-Party Solicitors• The written solicitation agreement must: (1) describe the

solicitation activities to be performed on behalf of the adviser and the compensation to be received; (2) contain an undertaking by the solicitor to perform his or her duties under the written solicitation agreement in a manner consistent with the adviser’s instructions and the Advisers Act and the rules thereunder; (3) require the solicitor, at the time of paid solicitation activities, to provide the client with the adviser’s brochure and a written disclosure document

• The adviser must receive a signed and dated acknowledgment of receipt of the adviser’s brochure and the solicitor’s written disclosure document prior to or at the time of entering into any advisory contract with the client

• The adviser must make a bona fide effort to ascertain whether the solicitor has complied with the agreement, and must have a reasonable basis for believing that the solicitor has complied

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─ Third-Party Solicitors• The solicitor must provide a separate written disclosure

document which contains the following information:• The solicitor’s name;• The adviser’s name;• The nature of the adviser and solicitor’s relationship • A statement that the solicitor will be compensated by the

adviser;• The terms of the compensation arrangement; • Any amount the client will be charged in addition to the

advisory fee; and• Any differential among clients with respect to the amount

or level of advisory fees charged by the adviser (if attributable to the existence of any solicitor arrangement)

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─ Key Takeaways from Compliance Issues Related to Third-Party Solicitors• Advisers must obtain acknowledgment that the client received

solicitor disclosure documents• Advisers must make sure that solicitor disclosure documents

include:• The nature of the adviser and solicitor’s relationship • The terms of the compensation arrangement • The actual compensation terms agreed to (avoid vague or

hypothetical terms)• The additional cost the client is charged in addition to the

advisory fee• Advisers must make sure that they receive, before or at the time

of entering the advisory agreement, signed and dated client acknowledgments for adviser brochures and solicitor disclosure documents

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─ Key Takeaways from Compliance Issues Related to Third-Party Solicitors• Advisers must make sure the written solicitation agreements

include:• An undertaking by the solicitor to perform its duties under the

solicitation agreement in a manner consistent with the adviser’s instructions

• A description of the solicitor’s activities and the compensation to be paid

• Requirements for solicitors to provide clients with the adviser’s brochure and solicitor disclosure document

• Advisers must be able to describe the bona fide efforts taken to ascertain whether third-party solicitors complied with solicitation agreements

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Preparing for Your Firm’s 2019 ADV Update


─ Potential Topics for New or Revised Disclosure

• Inadvertent Custody

• Senior Investors

• Advisory Fees and Expenses

• Best Execution

• Service Provider Referrals

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Preparing for Your Firm’s 2019 ADV Update: Inadvertent Custody


─ SEC Staff Responses to Questions about the Custody Rule –Question II.11 (Posted June 5, 2018)

• “An adviser that does not have a copy of a client’s custodial agreement, and does not know, or have reason to know whether the agreement would give the adviser Inadvertent Custody, need not comply with the custody rule with respect to that client’s account if Inadvertent Custody would be the sole basis for custody … We note, however, that this relief is not available where the adviser recommended, requested, or required a client’s custodian”

─ Disclosure for Consideration

• Notwithstanding language in clients’ custodial agreements granting the adviser custody over client assets, the adviser does not have custody over any such assets when it does not recommend, request or require clients to retain the custodian that has such language in its custodial agreement, does not have a copy of such agreement, and does not know, or have reason to know whether the agreement would grant custody

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Preparing for Your Firm’s 2019 ADV Update: Senior Investors


─ Senior Safe Act• Encourages investment advisers (and other financial services firms) to train

employees to spot elder abuse, while granting limited immunity to advisers and their associated persons for disclosing suspected exploitation of a senior citizen to a “covered agency,” such as the SEC, an SRO, a state securities regulator, or a law enforcement agency

─ FINRA Rule 2165 • Allows broker-dealers to place a temporary hold on the disbursement of customer

funds when they reasonably believe that “financial exploitation” has occurred• Provides a safe harbor from FINRA Rules 2010 (Standards of Commercial Honor and

Principles of Trade), 2150 (Improper Use of Customers’ Securities or Funds; Prohibition Against Guarantees and Sharing in Accounts), and 11870 (Customer Account Transfer Contracts) if certain conditions are satisfied

─ NASAA Model Act to Protect Vulnerable Adults from Financial Exploitation• Calls for certain reporting to state securities regulators and adult protective service

agencies when there is a reasonable belief of financial exploitation • Applicability to SEC registered investment advisers?

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Preparing for Your Firm’s 2019 ADV Update: Senior Investors



• Applicable law permits, and, in some cases, mandates, disclosure of suspected financial exploitation of senior investors and other vulnerable individuals to federal and state securities regulators, law enforcement, and adult protective services agencies

• Broker-dealers providing securities execution services in connection with advisory accounts may place a temporary hold on disbursing funds from a client’s account if there is a reasonable belief of financial exploitation, and in such a scenario, the investment adviser has no ability to override a decision to place a temporary hold or effectuate the release of such a temporary hold

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Preparing for Your Firm’s 2019 ADV Update: Advisory Fees and Expenses


─ There has been a high level of recent regulatory scrutiny in this area

• OCIE Risk Alert, “Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers” (Apr. 12, 2018)

• Enforcement activity – for example:

• Retirement Capital Strategies, Inc., Release No. IA-5065 (Nov. 19, 2018)

• Aisling Capital LLC, Release No. IA-4951 (June 29, 2018)

• Barclays Capital Inc., Release No. IA-4705 (May 10, 2017)

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Preparing for Your Firm’s 2019 ADV Update: Advisory Fees and Expenses


─ Review your existing disclosures carefully to ensure they are consistent with your actual practices – for example:

• Are any clients charged a fee rate exceeding the maximum disclosed fee rate, or that is different from the disclosed fee?

• Are clients being billed at the frequency stated in Form ADV and client agreements (monthly, quarterly, etc.)?

• Are clients receiving promised reimbursements for advisory services terminated mid-billing cycle?

• Are client assets against which the advisory fee rate is charged being valued in a manner consistent with disclosures?

• Are clients receiving promised rebates, householding discounts and breakpoints?

• Are all expense allocations to advised funds done in a manner consistent with disclosures to fund investors?

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Preparing for Your Firm’s 2019 ADV Update: Best Execution


─ OCIE Risk Alert, “Compliance Issues Related to Best Execution by Investment Advisers” (July 11, 2018)

─ Review your best execution and soft dollar disclosures to ensure that you are providing full and fair disclosure – for example:• Are there certain types of client accounts that may trade the same

securities after other client accounts? Is this fact, and the potential impact of this practice on execution prices, disclosed to clients?

• Are your disclosures regarding review of trades to ensure acceptable prices are obtained consistent with your actual practices?

• Are all soft dollar arrangements disclosed?• Will certain clients bear more of the cost of soft dollar arrangements

than other clients? If so, is this disclosed?• Has adequate and accurate disclosure been provided regarding

products and services acquired with soft dollars that do not qualify as eligible brokerage and research services under the Section 28(e) safe harbor?

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Preparing for Your Firm’s 2019 ADV Update: Service Provider Referrals


─ OCIE Risk Alert, “Investment Adviser Compliance Issues Related to the Cash Solicitation Rule” (October 31, 2018)


• Do you have any arrangements in place with service providers (such as custodians, broker-dealers, etc.) under which you recommend such service providers to your clients in exchange for client referrals? If so, is full and fair disclosure of the conflicts of interest associated with such arrangements provided to clients?

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Update on Federal and State Fiduciary Initiatives


─ SEC Proposed BD/IA Standard of Conduct:

• Establishes a broker-dealer “best interest” standard of conduct;• Requires broker-dealers and investment advisers to summarize their

relationship to retail investors using new Form CRS;• Restricts the use of the term “adviser” or “advisor” by broker-dealers;

and• Reaffirms and clarifies investment adviser fiduciary duty

─ 90-day comment period closed on August 7, 2018

─ According to SEC’s most recent regulatory agenda, final action on the proposed rule is expected by September 2019

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─ SEC’s Investor Advisory Committee

• Issued, by a majority vote (16-3), a “recommendation” on November 7

• General theme: more should be done to “strengthen and clarify” the rule proposal

• More specifically:

• Clarify what it means to act in customer’s “best interest”

• Extend “best interest” obligation to cover rollover recommendations and recommendations regarding account types (e.g., BD vs. IA) for dual registrants

• Explicitly characterize “best interest” standard as “fiduciary” obligation, with understanding that duties flowing from obligation would vary based on BD/IA business models

• Further testing to ensure Form CRS disclosures enable investors to make informed decisions between BD and IA account types

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─ RAND Research Report: Form CRS

• SEC’s Office of Investor Advocate engaged the RAND Corporation to conduct a nationwide survey of investors to gather feedback on Form CRS

• Report issued November 7• Conducted online survey of more than 1,800 investors• Qualitative in-depth interviews conducted in Denver and Pittsburgh by independent

market research firms

• Findings:• “Generally positive” assessments of format and content of Form CRS• Nearly 90% of survey respondents suggested that Form CRS would help them make a “more

informed decision” about investment accounts and services• More than 75% of survey respondents characterized Form CRS as “helpful” in understanding

key terms and potential conflicts of interest• 85% of survey respondents found side-by-side comparisons in Form CRS “helpful” in deciding

between BD and IA accounts• Majority of survey respondents felt Form CRS was “too long”• Interviews revealed confusion (especially in the “fees and costs” section), despite interview

participants stating that Form CRS “improved their understanding” of account types

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─ SEC Personnel and Statements

• SEC Commissioner Elad Roisman

• Sworn in September 11, 2018

• Republican member of Commission. Replaces Michael Piwowar

• During US Senate confirmation hearings, pledged to keep “open mind” on proposed rulemaking, but noted that rule should be “business-model neutral”

• SEC Commissioner Hester Peirce

• October 2018 speeches indicating support for both Regulation Best Interest and Form CRS

• Form CRS beneficial platform to advance digital disclosure system

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─ New Jersey

• October 2018 pre-proposal notice requesting comment on amendments requiring broker-dealers and investment advisers to be subject to a fiduciary duty

• Amendments would make it a “dishonest or unethical business practice” for failure to act in accordance with fiduciary duty when recommending a securities transaction, investment strategy, or providing investment advisory services

• Two informal conferences held in November 2018 to gather facts and inform rulemaking

• Comments due by December 14

─ Preemption?

─ Other states

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GIPS 2020: Introduction to GIPS


─ The GIPS standards are universal, voluntary standards developed by the CFA Institute, to be used by investment managers for quantifying and presenting investment performance that ensure fair representation, full disclosure, and apples-to-apples comparisons

─ GIPS has two principal components: the Performance Standards and the Advertising Guidelines

• Among other things, the Performance Standards specify how a firm constructs composites, calculates its performance, and presents that performance

• As defined in GIPS, a composite is an “aggregation of one or more PORTFOLIOS into a single group that represents a particular investment objective or strategy”

• Under GIPS, if a firm chooses to advertise that it is GIPS-compliant, it must comply with the GIPS Advertising Guidelines in addition to the Performance Standards

• The Advertising Guidelines require the disclosure of certain basic information regarding the firm in all advertisements claiming GIPS compliance

• In addition, where a firm discloses performance data in an advertisement claiming GIPS compliance, the Guidelines require the firm to disclose specific forms of returns

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GIPS 2020: Introduction to GIPS


─ Should you be compliant with GIPS?

• Pros• Claim of compliance is a marketing and credibility advantage

• Marketing and credibility advantages can be enhanced through choosing to have claims of GIPS compliance verified – i.e., review of performance measurement processes and procedures by an independent third-party verifier

• Necessary to complete in institutional market• Demonstrates high ethical standard

• Additional considerations• If you claim compliance, you must be compliant – no exceptions• Increased regulatory scrutiny• Work involved• Costs incurred

─ SEC’s position on GIPS

• Although compliance with GIPS is not required under the Advisers Act, the Staff closely monitors compliance and will continue to bring enforcement actions against advisers that misrepresent compliance with GIPS

• See, e.g., ZPR Investment Management, Inc., Release No. IA-4249 (Oct. 30, 2015)

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GIPS 2020: Background on and Purpose of Proposed Changes


─ In May 2017, the GIPS 20/20 Consultation Paper was released for public comments

─ The comments received helped to inform the Exposure Draft of the 2020 edition of GIPS, released on August 30, 2018

─ The comment period for the Exposure Draft closes on December 31, 2018

─ GIPS 2020 would have an effective date of January 1, 2020

─ Purpose of GIPS 2020 – to facilitate and encourage widespread adoption among alternative investment managers and managers of pooled funds

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GIPS 2020: Overview of Proposed Changes


─ New Structure for GIPS 2020• Standards would be restructured to try to reduce complexity and eliminate the need to go

back and forth between sections to determine which requirements apply• Each GIPS report section is self-contained and includes all items that must be considered

when creating the respective report for the composite

─ Addition of Key Requirements Included in Other Guidance• Standards would include key requirements currently appearing outside of GIPS 2010,

which include Guidance Statements, Questions and Answers, or GIPS Handbook provision discussions, as new provisions

─ Composites Versus Pooled Funds• Currently all actual, fee-paying, discretionary portfolios must be included in at least one

composite• Managers of pooled funds have questioned the logic behind the requirement to place all

pooled funds in a composite, even if it is a single-fund composite, because what is being sold is a participation in a pooled fund, not a composite

• CFA Institute recognizes that calling a pooled fund a composite, and presenting it as a composite, is not the best approach

• Under the proposal, there would no longer be a requirement to create a composite that includes only one or more pooled funds if the firm does not offer the strategy of the pooled fund(s) as a composite strategy to segregated accounts. However, if the pooled fund strategy is the same as a composite strategy, the pooled fund must be included in the composite and a GIPS Composite Report is required to be presented to prospective clients

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─ Limited Distribution Pooled Funds and Broad Distribution Pooled Funds• A firm selling participation in a limited distribution pooled fund (e.g., private funds, such

as hedge funds) is required to prepare and present a GIPS Pooled Fund Report to all pooled fund prospective investors

• A GIPS Pooled Fund Report for a limited distribution pooled fund is similar to a GIPS Composite Report, in that it will have required numerical and disclosure items, but reflects only the specific pooled fund’s information and is not based on a composite

• A firm selling participation in a broad distribution pooled fund is not required to prepare and present a GIPS Pooled Fund Report to all pooled fund prospective investors of the broad distribution pooled fund, but it may do so if it wishes

─ Money-Weighted Returns• Under GIPS 2010, there is a strict asset-class approach used to determine which returns

are required to be presented by closed-end fund managers• Private equity reports are required to include internal rates of return (IRRs) only• Closed-end real estate composites must include both IRRs and time-weighted returns (TWRs)• All other closed-end funds are required to present TWRs

• To provide flexibility to managers of closed-end funds (and specifically real estate funds), returns can be presented as either an internal rate of return (IRR) (now known as a “money-weighted return” or MWR) or time-weighted return (TWR), provided certain criteria are met

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─ Total Firm Assets and Advisory Assets• Allows firms to present assets that are not managed by the firm, but must be calculated

and presented separately from total firm assets• Restricts firms from including committed capital in total firm assets

─ Estimated Transaction Costs• In recognition of the fact that trading expenses have come down in cost, are not

standardized, can be charged in a variety of ways and may not be under a firm’s control, would allow estimated transaction costs for composites if returns calculated using estimated costs are equal to or lower than a calculation using actual costs

─ Portability• Currently, firms are required to link to performance from a prior firm, if portability tests

are met, on a composite-specific basis• In GIPS 2020, firms will be allowed to choose if they will link to performance from a prior

firm, if portability tests are met, on a composite-specific or pooled fund-specific basis• Clarifies the one-year grace period – i.e., assets of acquired non-compliant firm must

meet all requirements of GIPS within one year, on a prospective basis only• No limit on when firms may port history from the prior firm or affiliation (i.e., prior

performance not subject to one-year grace period)

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─ Carve-Outs• Would allow firms to once again allocate cash to carve-outs (i.e., a portion of a portfolio

that by itself is representative of a distinct investment strategy), subject to certain limits

─ Private Market Investments Valuation• All private market investments would be required to obtain an independent opinion on

valuation at least once every 12 months• Could be accomplished through an external valuation, a valuation review or a financial

statement audit

─ Timeliness of Updating Reports• Would include a requirement to update GIPS reports within six months of the annual

period end date

─ Time Period for Disclosures• Would allow some disclosures in GIPS reports to be deleted after one year if they are no

longer relevant to interpreting the performance track record

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Exam and Enforcement Developments: Reg S-ID and Reg S-P Enforcement


─ Reg S-ID, also known as the Identity Theft Rule, requires companies to develop and maintain written policies and procedures that detect, mitigate and prevent identity theft

─ Reg S-P requires companies to adopt written policies and procedures that address administrative, technical and physical safeguards for the protection of customer records and information

─ When determining violations and penalties under both rules, the SEC takes into account remedial measures taken immediately after a violation

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─ First Reg S-ID action by SEC was brought in September 2018 • Voya Financial Services (Sep. 26, 2018)

─ In 2016, the company fell victim to a “phishing incident” through which client personally identifiable information (PII) was compromised

─ The SEC determined that the company violated Reg S-ID because:• The company’s written program had not been updated since 2009• Employees were not trained adequately regarding identity theft risks • Reasonable procedures were not in place to prevent and respond to “red flags”• The company’s policies pertaining to resetting its contractor representatives’

passwords and identifying high-risk client and contractor accounts for extra protection were not reasonably designed

─ When reaching a settlement with the company, the SEC considered the company’s remedial actions including the company blocking malicious IP addresses and issuing breach notices to affected clients

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─ Key Takeaways • Don’t let your guard down

• This was the SEC’s first Reg S-ID enforcement action and a rare Reg S-P enforcement action. However, a lack of previous enforcement does not mean that the SEC won’t enforce these regulations in the future

• The rules will be enforced even if there is no harm to clients as a result of the breach

• The SEC acknowledged here that “[t]here have been no known unauthorized transfers of funds or securities” as a result of the attack.

• Yet, the SEC still brought an enforcement action because the intruders accessed and modified client account information

• It’s not enough to just have the procedures in place; they need to be applied and updated regularly

• Procedures must be functional and employees must receive proper training to be able to respond appropriately to threats

• Procedures must be responsive to external cybersecurity risks and a company’s personal risk profile

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A Look Ahead: The 2019 Regulatory Agenda


─ Proposed Amendments to the Marketing Rules Under the Advisers Act• The SEC anticipates proposing amendments to Rules 206(4)-1, 206(4)-3 and

204-2 in April 2019• Dalia Blass, Director, Division of Investment Management, Testimony before

the United States House of Representatives Committee on Financial Services, Subcommittee on Capital Markets, Securities and Investments (September 26, 2018)

• “[The] rule governing marketing . . . has not changed significantly since its adoption in 1961 . . . . [I]n 1961, investors did not have resources like the internet to research and select investment advisers, and social media in its current form did not exist. . . . As this landscape has evolved, the Division is considering recommendations for the Commission to modernize the rule”

─ Standard of Care Initiatives• The SEC anticipates adopting final rules with respect to Regulation Best

Interest, Form CRS and use of titles, and a final Investment Adviser Standard of Conduct Interpretation, in September 2019

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Questions?

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eversheds-sutherland.com© 2018 Eversheds Sutherland (US) LLPAll rights reserved.

Clifford KirschNew York, NY+1 212 389 [email protected]

Michael KofflerNew York, NY+1 212 389 [email protected]

Ben MarzoukWashington DC+1 202 383 [email protected]

Bria AdamsWashington DC+1 202 383 [email protected]

Issa HannaNew York, NY+1 212 389 [email protected]

advisers act regulatory series - eversheds sutherland · 2020-06-04 · preparing for your firm’s...

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