Tag Archives: Securities and Exchange Commission

SEC Staff Issues Guidance on Robo-Advisers

The Securities and Exchange Commission’s Division of Investment Management (“SEC”) recently published information and guidance for investors and the financial services industry on the use of automated advisers, or robo-advisers, which are registered investment advisers (“RIA”) that use computer algorithms to provide advisory services with limited human interaction.

Robo-Advisers are subject to the same fiduciary obligations under the Investment Advisers Act of 1940 (“Advisers Act”) as any other registered investment adviser. Since they rely on algorithms and limited interaction with clients, the model raises certain considerations when seeking compliance with the Advisers Act.

The guidance focuses on the following three issues: (1) the substance and presentation of disclosing to clients the services the RIA offers; (2) the obligation to obtain information from clients to provide suitable advice; and (3) the adoption and implementation of effective compliance programs specifically designed for robo-advisers.

DisclosuresIn order for clients to better understand how a robo-adviser provides its investment advice, the robo-adviser should; (1) explain its business model, including a description of the algorithm used to make recommendations; (2) clearly disclose the scope of its services; and (3) ensure clients understand and read the initial disclosure material and that the questionnaires used elicit a sufficient amount of information.

SuitabilitySimilar to all RIAs, a robo-adviser must act in the best interests of its clients and provide only suitable investment advice based on the client’s financial situation and investment objectives.  However, the questionnaires used by many robo-advisers may not request a sufficient amount of information.  The SEC recommends robo-advisers ensure questionnaires supplied to clients require enough information to make a suitable recommendation.

Compliance ProgramsRobo-advisers may have more risks than traditional RIAs.  These risks need to be addressed in their written policies and procedures in order to comply with Rule 206(4)-7 of the Advisers Act.  Robo-advisers should consider whether to adopt and implement written policies addressing the following areas: (1) the development and testing of the algorithm; (2) the initial investment objective questionnaire; (3) disclosing changes in the algorithmic code that may affect their portfolios; (4) oversight of any third party who develops, owns or manages the algorithmic code; (5) the use of social media in connection with marketing services; (6) the prevention and detection of cyber threats; and (7) the protection of client accounts and key advisory systems.

Robo-advisers represent a fast growing area of the investment advisory industry.  Click here to view the Guidance Update.

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The Five Most Frequent Compliance Topics Identified in SEC Examinations of Investment Advisers

The Five Most Frequent Compliance Topics Identified in SEC Examinations of Investment Advisers

The Office of Compliance Inspections and Examinations (“OCIE”) at the Securities and Exchange Commission (“SEC”) recently published a Risk Alert titled The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment AdvisorsThe five common deficiencies identified in the Risk Alert are compliance procedure; regulatory filings; the custody rule; code of ethics rules; and books and records. The OCIE hopes that in releasing the information, it will help advisers in their future compliance reviews.

Compliance RuleThe Compliance Rule requires advisers to adopt and implement written policies and procedures designed to prevent violations of the Investment Advisers Act of 1940 (“Advisers Act”).  Advisers often fall short in reviews when their compliance manuals are not reviewed annually. This is because the information is no longer current and/or the compliance manuals are not reasonably tailored to the adviser’s business practices.

Regulatory Filings Advisers are required to keep timely and accurate filings with the SEC. However, despite their obligations, advisers frequently fail to timely file complete Form ADV’s, Form PF filings and Form D filings. Furthermore, members of the OCIE observed that advisers frequently made inaccurate disclosures in Form ADV Part 1A or Form ADV Part 2A brochures.

The Custody Rule Advisers with custody of customers’ cash or securities must comply with the Custody Rule of the Advisers Act, which outlines safekeeping requirements for funds and securities within a registered investment adviser’s custody.   Advisers sometimes do not realize they must follow the Custody Rule if they maintain online access to their customers’ accounts. The OCIE additionally observed that advisers with custody obtained surprise examinations that did not meet the requirements of the Custody Rule – i.e., examinations were not conducted on a “surprise” basis.

Code of Ethics The Code of Ethics Rule requires advisers to maintain a code of ethics.   According to the OCIE, typical deficiencies include: advisers not identifying all their “access persons” (supervised persons who have access to nonpublic information about advisory clients’ purchase or sale of securities or are involved in or have access to securities recommendations made to clients); advisers failing to report their personal securities transactions; advisers making untimely reports; and advisers leaving out the description of the code of ethics in their Form ADV Part 2A brochure.

Books and Records Rule The Books and Records Rule requires advisers to make and keep certain books and records relating to their investment strategy.  The deficiencies that the OCIE highlighted relating to this rule are: the failure to maintain records; inconsistent record keeping; and inaccurate or not updated records.

In sharing this information, the OCIE and DWH Legal hope to encourage advisers to review and update their practices, policies, and procedures.  Click here to view the full Risk Alert and contact us with any questions.

SEC Examination Priorities for 2017

The Securities and Exchange Commission (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) recently released its annual Examination Priorities. It focuses on practices, products, and services that present potentially heightened risk to investors and/or the integrity of the U.S. capital markets.

The priorities are organized around three areas: (1) retail investors; (2) senior investors and retirement investments; and (3) market-wide risks.

Retail Investors – OCIE is pursuing a variety of examination initiatives to assess potential risks to retail investors highlighting: (i) electronic trading advice and the overseeing algorithms that generate recommendations; (ii) wrap fee programs; (iii) exchange-traded funds; (iv) never-before examined investment advisers; (v) recidivist representatives and their employers; (vi) multi-branch advisers; and (vii) share class selection.

Senior Investors and Retirement Investments – As the U.S. population ages, OCIE will increase attention on its (i) ReTIRE initiative; (ii) public pension advisers; and (iii) senior investors.  To this end, the OCIE will focus on recommendations and sales of variable insurance products, pay-to-play and undisclosed gifts and entertainment practices and supervisory programs and controls relating to products directed at senior investors.

Assessing Market-Wide Risks – In order to maintain fair, orderly and efficient markets, OCIE will focus on the following initiatives: (i) money market funds; (ii) payment for order flow and firms duty of best execution; (iii) clearing agencies; (iv) the quality of FINRA examinations; (v) regulation systems compliance and integrity; (vi) cybersecurity; (vii) national securities exchanges; and (viii) anti-money laundering.

OCIE recognizes the above list is not exhaustive and expects to allocate resources to other priorities including municipal advisors, transfer agents, private fund advisers, and will continue to conduct examinations focusing on new matters that arise from new market developments.

Click here to read the SEC 2017 Examination Priorities Letter.

Click here to read about FINRA’s 2017 Regulatory and Examination Priorities.

Please contact Chicago attorney, Doug Hyman, with questions about our firm’s regulatory practice.

FINRA Amends Customer Code of Arbitration Procedure Regarding Panel Selection in Cases with Three Arbitrators

The SEC approved amendments to FINRA Rule 12403 of the Code of Arbitration Procedure for Customer Disputes, increasing the number of arbitrators on the public arbitration list from 10 to 15, and increasing the number of strikes to that same list from four to six.  The chairperson and non-public arbitration lists will remain unchanged at 10 arbitrators each.

Under current FINRA rules, in customer cases with three arbitrators, FINRA sends the parties three lists (one list for each selected arbitrator):  (1) a list of 10 potential chair-qualified public arbitrators; (2) a list of 10 potential public arbitrators; and (3) a list of 10 potential non-public arbitrators.  Using these lists, the parties then select their panel by striking up to 4 potential arbitrators on the chair-qualified and public arbitrator list, and unlimited striking on the non-public arbitrator list.  Each of the parties then ranks the remaining arbitrators on their lists.

Under FINRA rules, if all of the non-public arbitrators are struck, FINRA will first look to fill the remaining arbitrator from the remaining choices left on the public arbitrator list.  If no arbitrator remains after all strikes, FINRA looks to fill the panel using any remaining arbitrator from the chair-qualified public arbitrator list.

By increasing the number of arbitrators on the public arbitrator list from 10 to 15, FINRA believes there is a greater likelihood of FINRA appointing arbitrators both parties accepted, particularly in cases where the parties collectively strike the non-public arbitrator list.

The amendments become effective for all arbitrator lists that FINRA sends to parties on or after January 3, 2017 for panel section in customer cases with three arbitrators.

Click here to view the applicable Regulatory Notice, which includes the text of amended Rule 12403.

SEC Amends Rules of Practice for Administrative Proceedings

The SEC recently enacted amendments to its Rules of Practice for Administrative Proceedings, making changes first proposed by the Commission in September 2015. The new amendments address recent criticism regarding the SEC’s increased use of administrative proceedings and the perceived lack of due process afforded in such proceedings. The rule changes have two major objectives: lengthening the prehearing timeline for administrative proceedings and increasing certain discovery rights such as allowing for depositions.   The amended rules become effective 60 days after publication in the Federal Registrar and will govern all proceedings initiated on or after that effective date.

Some of the key rule changes include:

  • Initial Decision of Hearing Officer (Rule 360): As amended, under Rule 360(a)(2), the time period for preparation of initial decision must be designated in the instituting proceedings as 30, 75 or 120 days from completion of post-hearing or dispositive motion or finding of default. Amended Rule also increases the maximum duration of the pre-hearing period. The previous unilateral maximum of four months for all proceedings has been expanded to up to ten months for proceedings designated as 120 days, six months for those designated as 75 days, and four months for those designated as 30 days.
  • Depositions upon Oral Examination (Rule 233): The new Rule 233 will permit the right to notice up to three depositions per side for single-respondent cases and five depositions per side in multi-respondent cases in 120-day proceedings, with an additional two depositions available upon request in an expedited procedure. There are still no depositions permitted for 30-day or 75-day proceedings.
  • Answer to Allegations (Rule 220): Amended Rule 220 will require a Respondent in its Answer to disclose whether a “reliance” defense will be asserted and whether there was reliance on advice of counsel, accounts, auditors or other professionals in connection with any claim, alleged violation or sought remedy.
  • Experts (Rule 222): Rule 222 will require a party planning to call an expert witness to submit a statement of the expert’s qualifications with prior testimony of up to four years old and publications of up to ten years. Previously there were no such time limitations. Additionally, the Rule will now require filing of an expert report including:  (1) all opinions the witness will use and the basis and reasons behind them; (2) the facts and figures considered to form those opinions; (3) any exhibits used to summarize or support the expert’s opinions; and (4) all compensation paid to the expert.

Click here to view the SEC’s release

SEC Approves FINRA Rule Requiring Firms to Provide an “Educational Communication” to Former Clients of Transitioning Registered Representatives

The SEC approved a disclosure rule proposed by FINRA requiring that member firms hiring or associating with a registered representative provide the representative’s former clients an “educational communication” to be written by FINRA.   The communication is intended to prompt a former client to make further inquiries of the representative and their new and old firm to the extent that the client considers the information important to their decision making.

The communication will not disclose the specifics of the transitioning representative’s compensation with their new firm.  Rather, the communication will outline in general terms things the client may consider in connection with their decision to move their accounts, such as (1) whether financial incentives received by the representative may create a conflict of interest; (2) that some assets may not directly transfer to the new firm and as a result the customer may incur costs to liquidate and move those assets or account maintenance fees to leave them with their current firm; (3) potential costs related to transferring assets to the new firm; and (4) differences in products and services between firms.

The communication will be required when the former client is contacted by the representative or their new firm to transfer assets, or absent contact by the representative or their new firm, when a former client transfers assets to the representative at their new firm.

The implementation date for the rule has not been determined.

Click here to view the SEC’s Order approving the FINRA rule.

The SEC Highlights Growing Concerns About Private Tech Startup Funding To Eager Investors

By: DWH Legal

On Wednesday, at the annual Securities Regulation Institute conference in Coronado, California, Securities and Exchange Commission Chair Mary Jo White shared the agency’s growing  concern about the aggressive promotion of private tech startup companies to investors.  The SEC’s concern centers around investors unable to receive sufficient or accurate information when choosing to make investments.

Many tech startups are choosing to stay private longer than in previous capital booms.  According to Renaissance Capital, last year only 23 tech IPOs occurred, compared to 55 in 2014.  In addition, several tech startup companies that went public have found that their valuation on Wall Street is often lower than in the private space.  According to Business Insider, “unicorn” startups (private tech startups with valuations north of $1 billion) like Box (BOX), Pure Storage (PSTG), and Zynga (ZNGA) went public well below their last round of private valuations.  For example, Square (SQ) which went public in November 2015 is only valued at $3.2 billion – a big downgrade from its $6 billion valuation following a round of private financing in 2014.  By staying private, tech startups do not face the obligations of public companies in issuing quarterly earnings reports and holding investor calls.  Accordingly, the stock of these companies doesn’t sell off immediately after a negative quarterly call, and such companies face far less market volatility.

It is under this backdrop that shares of private startup tech companies are being marketed to eager investors less sophisticated than venture capitalists in startup valuation.  Investors “may get very excited from an article or a blog and invest their money … You worry about them not getting sufficient or accurate information” explained Ms. White.   The SEC wants to make sure that aggressive promoters are not taking advantage of investors in this current climate.  If you have any questions in regards to the foregoing, please contact Principal Associate, Douglas Hyman, at (312) 380-6587.