Funds and Investment Management

July 2017

Regulatory Update and Recent SEC Enforcement Actions

REGULATORY UPDATE

Department of Labor (“DOL”) Fiduciary Rule Partially Goes into Effect

On June 9, 2017, after a near two month delay, the DOL’s controversial Fiduciary Rule (“the Rule”) became partially effective. The Rule expands the definition of what constitutes a fiduciary in the context of providing recommendations, advice, or marketing to retirement investors for a fee or other compensation (both direct and indirect). As a fiduciary, the Rule requires one to provide investment advice with prudence and loyalty based on the investment objectives, risk tolerance, financial circumstances, and needs of the plan or IRA, without regard to the financial interests of the investment adviser or firms. Essentially, the Rule requires advisers and other retirement professionals to act in the “best interest” of the client. As such, the Rule has various implications to a broad range of advisers, and therefore, individual advisers should consider how the Rule applies to their specific business practices and compensation structures as they relate to providing investment advice to retirement investors. Specifically, the Rule requires fiduciaries, who “recommend” new investment proposals to retirement investors, to document, among other things, the reasons the proposed arrangement is considered to be in the best interest of the retirement investor and disclose all direct and

indirect income received by the adviser as well as any conflicts of interest that exist. Additionally, the Rule provides certain exemptions depending on one’s fiduciary status and whether the compensation received is a level or a variable fee. Furthermore, all pre-existing retirement assets under management prior to June 9, 2017, are “grandfathered” and are exempt from the Rule. Lastly, the DOL established a “transition period” between June 9 and December 31, 2017, whereby advisers are permitted to make a best effort to comply with the Rule. During this time, the Rule remains effective, however, the DOL, Treasury Department, and IRS will not pursue claims against fiduciaries who are making their best effort to comply with the Rule. Paralleling the DOL, a version of the Rule is also being considered by the U.S. Securities and Exchange Commission (“SEC”). On June 2, 2017, SEC Chairman Jay Clayton asked for public input with respect to how the Rule will influence SEC regulated retail investors and related entities. “The Department of Labor's fiduciary rule may have significant effects on retail investors and entities regulated by the SEC. It also may have broader effects on our capital markets. Many of these matters fall within the SEC's mission of protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation,” Mr. Clayton stated. The SEC will post public comments on the agency’s website.

In addition, on June 2, 2017, Nevada became the first state to pass a bill making a statewide fiduciary standard applicable to financial advisers. Politicians in other states have reached out to Nevada officials regarding implementing similar legislation in their states.

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SEC Office of Compliance Inspections and Examinations (“OCIE”) Issues Cybersecurity Ransomware Alert on WannaCry Attack

On May 12, 2017, a pervasive ransomware attack called “WannaCry” attacked various financial institutions and other organizations across more than 100 countries, infecting computers with malicious software that locked user files with encryption codes. WannaCry then demanded ransom payments from users in order to restore access to the locked files. To protect against WannaCry and similar attacks in the future, OCIE suggests that broker-dealers and investment management firms: (1) review U.S. Cert Alert TA17-132A, published by the U.S. Department of Homeland Security, and (2) assess applicable Microsoft operating system patches to ensure that they are installed properly and timely. The OCIE staff recently reviewed 75 SEC registered broker-dealers and investment management firms to evaluate industry-wide cybersecurity practices as well as assess related issues in the legal, compliance, and regulatory space. Specifically, with respect to the WannaCry ransomware attack, OCIE made the following assessment: (1) five percent of broker-dealers and 26 percent of investment management firms failed to conduct periodic risk assessment tests of critical systems necessary for identifying cybersecurity threats and weaknesses; (2) five percent of broker-dealers and 57 percent of investment management firms did not conduct penetration tests and vulnerability scans on systems likely to be found critical; and (3) all broker-dealers and 96 percent of investment management firms maintain processes for ensuring regular system maintenance, however, only 10 percent of broker-dealers and four percent of investment management firms executed critical and high-risk security software updates. The Division of Investment Management and OCIE published guidance on cybersecurity-related risks and protection in April 2014, which is available at: www.sec.gov/investment/im-guidance-2015-02.pdf.

Implications of Section 858 of the Financial Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs Act (“CHOICE Act 2.0”)

On June 8, 2017, the U.S. House of Representatives passed the CHOICE Act 2.0, which seeks to undo and deregulate many of the regulations in the Dodd-Frank Act of 2010 (“Dodd-Frank”). Although the proposed legislation must still pass in the Senate (which legislation likely will not be voted on until 2018 and could be revised in many respects before then) the CHOICE Act 2.0 will have significant implications on private equity funds. Specifically, Section 858 of the CHOICE Act 2.0 exempts private equity fund advisers from being required to adhere to the SEC’s registration and reporting requirements “with respect to the provisions of

investment advice relating to a private equity fund.” Additionally, the provision requires that the SEC issue regulations requiring exempted advisers to keep records and provide the SEC with annual and other reports as determined by the SEC. Nonetheless, exempt advisers will remain subject to the Investment Advisers Act’s anti-fraud provisions. Furthermore, the CHOICE Act 2.0 accedes to the SEC to determine a proper definition for exempt private equity funds’ advisers. As such, a narrow term could limit the amount of advisers eligible for exemption, and thus undermine the CHOICE Act 2.0’s scope. Ultimately, the SEC will be permitted to determine the scope of these reporting requirements as the agency can adopt such requirements that are “necessary and appropriate in the public interest and for the protection of investors” while considering fund size, governance, investment strategy, risk, and related factors.

SEC to Increase Focus on Robo Advisers

On June 14, 2017, Steven Levine, an associate regional director at the SEC’s Chicago office, revealed that SEC Chairman Jay Clayton intends to focus on exam sweeps of robo advisers. Specifically, Levine mentioned that the agency plans to evaluate and focus on how investment advisory firms utilize robo advisers and how they generate automated investment advice to clients. The examinations will largely tailor to the SEC’s guidelines on digital advice platforms, which were released in February 2017. The SEC guidelines stated that robo advisers are subject to fiduciary duties and their operators must consider the same conflict and disclosure issues as human advisers. The SEC’s intensified focus on robo advisers should not come as a surprise, as industry insiders project that automated advisers will manage roughly $400 billion in assets by the end of 2018.

RECENT SEC APPOINTMENTS

SEC Announces Co-Directors of Enforcement Division

On June 8, 2017, the SEC announced that Stephanie Avakian, the acting director of the Enforcement Division, will be joined by Sullivan & Cromwell Partner Steven Peikin as co-heads of the agency’s largest group. Avakian replaced former director Andrew Ceresney in December 2016 and had been serving as acting director since. Peikin served as an assistant U.S. attorney in the Southern District of New York (“S.D.N.Y.”) from 1996 to 2004. At the S.D.N.Y., Mr. Peikin was the chief of the Office’s Securities and Commodities Fraud Task Force and oversaw high profile cases involving accounting fraud, insider trading, market manipulation, and foreign market exchange abuses.

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Other SEC Appointments:

���� Dalia Blass, Head of Division of Investment Management���� Keith E. Cassidy, Office of Compliance Inspections and Examinations, Associate Director of Technology Controls���� Kathryn A. Pyszka, Associate Regional Director for Enforcement (Chicago)���� Kelly L. Gibson, Associate Regional Director for Enforcement (Philadelphia)���� Robert Evans III, Deputy Director of Division of Corporate Finance

New Head of SEC’s Enforcement Division Views Cyber Security as Biggest Concern

On June 14, 2017, SEC Co-Director and head of enforcement Stephanie Avakian stated in an interview that she and newly-appointed Co-Director Steven Peikin both view cybersecurity as the most important enforcement policy. Avakian noted that the SEC has begun seeing an “uptick” in the amount of investigations relating to cybercrime as well as an increase in reports from brokerage accounts claiming cyber invasions. The SEC has noticed various instances of cybercrimes including stolen information to be used in insider trading and into hacking accounts to steal assets, to trade against them or even to manipulate markets.

ENFORCEMENT ACTIONS

SEC v. Revelation Capital Management (Case No. 14-cv-645, S.D.N.Y.)

On March 27, 2017, Judge Valerie Caproni of the Southern District of New York (“S.D.N.Y.”) granted the defendant’s motion for summary judgment ruling that the “primary focus” of Rule 105 of Regulation M under Section 10(b) of the Securities Exchange Act (“Rule 105”) is the “purchase of offering shares.” Rule 105 prohibits a person from purchasing securities in a firm commitment offering whereby that same person sold short the security at issue within the restricted period—generally five days prior to the pricing of the offering. According to SEC Release No. 34-56206, dated August 6, 2007, the purpose of this rule is to “safeguard the integrity” of the offering process and to “protect issuers from manipulative activity that can reduce issuer’s offering proceeds and dilute security holder value.” In 2009, the SEC sued Revelation Capital Management, Ltd. (“Revelation”) and its founder, Christopher P.C. Kuchanny, alleging that they violated Rule 105 by purchasing a Canadian company’s stock during the company’s offering after previously shorting the same company’s stock during the restricted period. The defendants moved for summary judgment on two grounds: (1) the Canadian company’s offering was not conducted on a firm commitment basis as proscribed by Rule 105, and (2) the SEC’s claim should have been barred by the decision in Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010). In Morrison, the U.S. Supreme Court held that the Securities and Exchange Act of 1933 did not provide a cause of action to foreign plaintiffs suing foreign and American defendants for misconduct in connection with securities traded on foreign stock exchanges. In other words, the defendants argued that Rule 105 lacked extraterritorial reach and did not extend to Canadian offerings. Judge Caproni found that the SEC’s Rule 105 claim failed to meet the Morrison legal framework as the defendants had not incurred “irrevocable liability” for the purchase of shares in the Canadian offering, and furthermore, title did not pass with respect to that purchase within the United States. Courts use the irrevocable liability standard as a means to determine where a securities transaction occurred, and in doing so, judges will often evaluate factors such as the placement of purchase orders and the passing of title. As such, the court held that the SEC’s argument that the defendants’ previous short sales of shares listed on the New York Stock Exchange satisfied Morrison.

“ There is no place for bad actors in our capital markets, particularly those that prey on investors and undermine confidence in our economy. Stephanie and Steve will aggressively police our capital markets and enforce our nation’s securities laws as co-directors of the Division of Enforcement.”

– Jay Clayton, SEC Chairman

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United States v. Rafal (Case No. 1:17-cr-10004, D. Mass.)

On April 20, 2017, former Connecticut investment adviser and president of Essex Financial Services Inc. (“Essex”) John Rafal was sentenced to one year of probation and four months of home detention, plus a $4,000 fine for obstructing an SEC investigation relating to surreptitious referral fees paid to an attorney. Rafal paid attorney Peter Hershman $50,000 for referring the attorney’s client, an elderly widow with accounts valued at more than $100 million, to Essex. Prosecutors argued that this fee violated both federal and state regulations. The SEC launched an investigation into Rafal and Hershman’s dealings. During the investigation, that Rafal testified that the inappropriate referral fee had been repaid; however, Rafal failed to mention that he had written Hershman a personal check for the referral fee after Essex demanded Rafal and Hershman cut ties. Rafal and Hershman settled with the SEC for obstructing the investigation. Rafal paid $575,000 and Hershman paid $90,000 in penalties. Both Rafal and Hershman are also barred from the securities industry, cannot serve as officers or directors of publicly-traded companies, and cannot appear before the SEC as attorneys.

Beware of Enforcement Actions Regarding Insufficient Cybersecurity Disclosures

On April 20, 2017, Enforcement Director Stephanie Avakian told an audience of attorneys that although the SEC has not previously launched formal action (investigation and prosecutions) against a public company for neglecting to report cybersecurity-related incidents and risks, it may institute such actions in the future. While the agency would likely not investigate companies that make good-faith attempts to comply with disclosure requirements, it may also be more willing to investigate companies that fail to maintain sufficient disclosure policies. A company has an obligation to disclose cyber-related incidents and risks such as when cyber-related issues arise that would make investing in the company risky. Although the SEC has yet to bring an action

against a company for lack of disclosures regarding cyber-related issues, the agency has actively enforced against violations of its “safeguards rule,” which requires investment advisers to protect consumer records. For example, in June 2016, Morgan Stanley Smith Barney LLC agreed to pay $1 million in penalties for failing to protect internal client information systems from improper access by its employees.

Recent Trends Regarding SEC Enforcement Action Priorities

On April 21, 2017, Cornerstone Research circulated a report detailing key shifts in SEC enforcement actions. Overall, enforcement actions remained largely unchanged as the SEC filed 334 actions in the first half of fiscal year 2017 compared to 372 actions brought in the first half of fiscal year 2016. Some of the findings comparing the first half of fiscal year 2016 with first half of fiscal year 2017 include:

���� enforcement actions brought over issuer reporting and disclosure increased by one-third from 49 to 59;���� enforcement actions related to broker-dealers increased by one-fifth from 69 to 83;���� enforcement actions regarding securities offerings jumped by one-third from 44 to 59;���� enforcement actions involving insider trading decreased by roughly one-third from 21 to 14; and���� enforcement actions related to the Foreign Corrupt Practices Act (“FCPA”) declined by about one-third from 10 to 7.

SEC v. Broidy et al. (Case No. 1:16-cv-05960, E.D.N.Y.)

On May 26, 2017, Marc Broidy, head of Broidy Wealth Advisors LLC, settled with the SEC by agreeing to pay approximately $1.7 million in disgorgement relating to an earlier guilty plea in a parallel criminal suit involving investment adviser fraud. The SEC alleged that from November 2010 to July 2016, Broidy maintained authority to trade securities in his wealthy clients’ brokerage accounts and could deduct management fees thereafter. However, instead of deducting proper amounts in fees, Broidy allegedly procured over $640,000 in excess fees and then forged his clients’ IRS Form 1099 in order to hide the excessive withdrawals. When one client uncovered Broidy’s fraud, Broidy settled with the client by selling approximately $865,000 worth of stock held in a trust for a different client’s children. The aforementioned settlement with the SEC also bars Broidy from serving as an officer or director of a publicly-traded company as well as from any future violations of the Securities Act, Exchange Act, and Investment Advisers Act.

“ The greatest threat to our markets right now is the cyber threat. That crosses not just this building, but all over the country.”

– Steven Peikin, SEC Co-Director

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In The Matter of Laurence I. Balter d/b/a Oracle Investment Research (Case No. 3-17614)

On May 30, 2017, Laurence I. Balter settled with the SEC, agreeing to pay approximately $490,000 in disgorgement and $50,000 in civil penalties, plus $10,000 in interest without admitting or denying the allegations made against him in October 2016. According to the SEC, Balter, the founder and sole proprietor of advisory firm Oracle Investment Research (“Oracle”), allegedly executed trades for himself and others through a single, omnibus account after he already knew of the profitability of each trade. In doing so, Balter successfully “cherry-picked” the most profitable trades for himself while leaving his clients with less profitable or losing trades. However, this maneuver ran counter to the SEC’s claim that Balter pledged on SEC forms that he would put client trades before any personal transactions. Furthermore, Oracle’s compliance manual obligated Balter to give priority on all trades to clients before making trades into his own proprietary account. According to the SEC complaint, Balter’s clients did not know that Balter had cherry-picked profitable trades for himself, and he underreported his clients’ losses in daily e-mails to them. Balter’s settlement with the SEC also bars him from the investment advisory business, and orders him to cease and desist from violating any future securities laws.

U.S. v. Kang et al. (Case No. 1:16-cr-00837, S.D.N.Y.)

On May 30, 2017, Deborah Kelley, a former managing director of institutional fixed-income sales at a New York broker-dealer, pled guilty to one count of conspiracy to commit honest services in a pay-for-play scheme. According to the SEC, Kelley bribed Navnoor Kang, director of fixed income and head of portfolio strategy for the New York State Common Retirement Fund, by paying for a ski trip to Utah for Kang and his girlfriend. In court, Kelley admitted that she paid for the ski trip in order to strengthen relations with Kang and recognized that her actions were wrong. However, she contended that she did not know that bribing a public official with a ski trip was illegal. Kelley was originally charged in December with providing Kang with over $100,000 in bribes, which ultimately brought in hundreds of thousands of dollars for her firm. Per her plea deal, the government waived prosecution of additional fraud charges and obstruction of justice while Kelley waived her right to appeal any sentence for less than or equal to 60 months in prison. Kang is expected to stand trial in December 2017.

Tilton et al. v. SEC  (Case No. 16-906)

On May 30, 2017, the U.S. Supreme Court denied former founder and CEO of private equity firm Patriarch Partners (“Patriarch”) Lynn Tilton’s writ of certiorari challenging the constitutionality of the SEC’s administrative law judges. In March 2015, the SEC alleged that Tilton and Patriarch covered up weak performances of companies in which her investment vehicles, called the “Zohar funds,” were invested. Allegedly, Tilton neglected to adhere to the valuation methods laid out in investment documents that permitted her to collect excessive management fees and retain authority over the funds’ operations. Tilton then countered the SEC’s claims by filing her own suit, arguing that the SEC’s administrative law judges violated the Appointments Clause of the Constitution because the judges are hired, not appointed by the President, the courts, nor the SEC. A New York federal court dismissed Tilton’s suit for lack of jurisdiction and the Second Circuit affirmed the lower court’s ruling in June 2016. The Second Circuit concluded that Tilton was prohibited from bringing a federal suit challenging the constitutionality of the SEC’s proceedings, in essence reaffirming the Second Circuit’s decision.

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Kokesh v. SEC (Case No. 16-529)

On June 5, 2017, the U.S. Supreme Court held that disgorgement collected by the SEC fell under the five-year statute of limitations for civil penalties. Previously, the Tenth Circuit concurred with the D.C. Circuit and First Circuit finding that the five-year statute of limitations did not apply, reasoning that disgorgement is not a penalty. In a separate and unrelated case, the Eleventh Circuit held that disgorgement is equivalent to forfeiture, and thus subject to the five-year statute of limitations. Because of the Circuit split, the Supreme Court ruled on the issue. The Supreme Court’s decision now significantly diminishes the SEC’s disgorgement order against former New Mexico adviser Charles R. Kokesh, who appealed a jury judgment ordering him to disgorge $35 million, plus over $18 million in interest and $2.4 million in penalties. Kokesh was ordered to disgorge ill-gotten profits made by misappropriating funds from four business development companies from 1995 through July 2007. As a result of the court’s decision, Kokesh will now only be forced to disgorge approximately $2.4 million, the amount of funds that he received during the limitations period.

Raymond James Lucia Cos. Inc. v. SEC (Case No. 15-1345, D.C. Cir.)

On June 26, 2017, an en banc D.C. Circuit court split evenly in determining whether the SEC can overrule decisions made by the agency’s own administrative law judges. Raymond J. Lucia and his investment advisory firm brought the appeal in hopes of overturning a previous decision made in August 2016 by a three-judge D.C. Circuit panel. The panel found that the SEC’s use of administrative law judges to hear cases was proper, refusing to overturn a December 2013 SEC decision banning Lucia for life from investment-related work and imposing a $300,000 fine relating to claims that he misled investors regarding the effectiveness of his investment strategy known as “Buckets of Money.” In December 2016, the Tenth Circuit came to a different conclusion in a separate case, ruling in favor of a defendant who challenged sanctions leveled against him by the SEC. Because of the conflict between the D.C. Circuit’s and the Tenth Circuit’s decisions, the U.S. Supreme Court will now have the opportunity to grant certiorari and potentially resolve the Circuit split.

California Public Employees’ Retirement System v. ANZ Securities Inc. et al. (Case No. 16-373)

On June 26, 2017, the U.S. Supreme Court held that the California Public Employees’ Retirement System (“CalPERS”) was untimely in attempting to opt-out of a securities class action, and ruled that suits relating to securities offerings and sales are subject to a statute of repose that cannot be tolled. The Court ultimately upheld the Second Circuit’s decision to dismiss CalPERS’ opt-out action against underwriting group ANZ Securities Inc. (“ANZ”) by concluding that the three-year time limitation in Section 13 of the Securities Act of 1933 operates as a statute of repose that may not be tolled by the filing of a class action suit. The CalPERS case arose from a class action suit brought by another retirement fund in June 2008, which alleged that multiple firms, including ANZ, involved in underwriting debt offerings from Lehman Brothers Holdings Inc., should have been held liable for false and misleading statements in Lehman’s registration statements. When the lawsuit stalled, CalPERS filed its own suit in 2011, which was later consolidated with the class claims. Ultimately, the proposed class settled and CalPERS opted out to pursue its own claims individually. However, the district court dismissed CalPERS’ claims as untimely because they were not brought within the aforementioned three-year statutory limit.

Digital Realty Trust Inc. v. Paul Somers (Case No. 16-1276)

On June 26, 2017, the U.S. Supreme Court granted certiorari to Digital Realty Trust Inc.’s (“Digital”) claim that the Ninth Circuit incorrectly found that internal whistleblowers are protected by the Dodd-Frank Act’s anti-retaliation provision regardless of whether or not they reported securities laws violations to the SEC. In November 2014, Paul Somers alleged that he was discriminated against by Digital for being an openly gay man despite his performance. Somers claimed that he was terminated based on “vague, trivial and false allegations of misconduct” following a complaint he made to senior management that a senior vice president had removed internal corporate controls in violation of the Sarbanes-Oxley Act. In March 2017, the Ninth Circuit found, similar to the Second Circuit, that Dodd-Frank’s whistleblower anti-retaliation provision “unambiguously and expressly protects” both those who report violations to the SEC

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©2017 Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.

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as well as internal whistleblowers. The Fifth Circuit has previously held that only those who report to the SEC are whistleblowers. The Sixth Circuit considered similar issues in an appeal brought by a former Morgan Stanley employee but refused to rule on the issue, determining that the claims were too vague to afford that plaintiff whistleblower protections. Specifically at issue in the Digital case is subdivision (iii) of Section 21F of Dodd-Frank, which prohibits employers from discharging or discriminating against a whistleblower who makes disclosures that are required or protected by Sarbanes-Oxley. The U.S. Supreme Court will review whether the Dodd-Frank Act prohibits retaliation against internal whistleblowers who haven’t reported concerns about securities law violations to the SEC.

Cyan Inc. et al. v. Beaver County Employees Retirement Fund et al. (Case No. 15-1439)

On June 27, 2017, the U.S. Supreme Court accepted Cyan Inc.’s (“Cyan”) petition to determine whether the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) removed state courts’ jurisdiction over securities class actions brought under the Securities Act of 1933. In this case, investors led by the Beaver County Employees Retirement Fund sued Cyan in 2014, alleging that Cyan violated the 1933 Act by not disclosing foreseen issues relating to the company’s revenue stream, which led to a decline in stock after financial analysts downgraded the company’s price targets. Cyan moved for summary judgment on the pleadings in August 2015, countering that SLUSA precluded state court jurisdiction over the plaintiff’s claims, however, the motion was denied by a California state court, while the state’s appeals court and highest court both declined to review the lowest court’s decision.