Author: Steven Howard
SEC proposes rules addressing broker-dealer and investment adviser standards of conduct
On April 18, 2018, the U.S. Securities and Exchange Commission (SEC) proposed a package of rules and interpretations intended to improve brokers’ standards of conduct for retail investors. The proposed rules and interpretations would
- Create a principles-based standard of conduct for broker-dealers and require broker-dealers to act in the best interest of their retail customers (referred to as Regulation Best Interest).
- Clarify and reaffirm investment advisers’ fiduciary obligations under the Investment Advisers Act of 1940.
- Create additional disclosure obligations for broker-dealers and investment advisers that are intended to help retail investors understand the scope and material facts concerning their relationship with investment professionals.
The SEC noted that the proposed rules and interpretations are the culmination of years of study by its staff of previously gathered data related to the provision of investment advice to retail investors. The SEC also noted that these proposals generally draw from the principles underlying the Department of Labor’s best interest standard which will not become law because of the recent Court of Appeals decision (see below).
The SEC’s proposals, if adopted, could impact the distribution and servicing arrangements for mutual fund shares. For example, the SEC highlighted mutual fund shares class selection as an area that may require particular consideration under the new best interest obligation in light of different cost structures and conflicts of interest associated with sub-transfer agency and other similar fees often paid to broker-dealers.
Importantly, the SEC’s proposals also include Federal licensing and continuing education requirements for personnel of investment advisers, delivery of account statements to clients with advisory fee and expense disclosures, and financial responsibility requirements for advisers, including fidelity bonds.
Fifth circuit court of appeals vacates DOL fiduciary rule; Fifth circuit denies motions to intervene in case invalidating DOL fiduciary rule
On March 15, 2018, the Court of Appeals for the Fifth Circuit, in Chamber of Commerce v. US Department of Labor, vacated the fiduciary rule of the Department of Labor (DOL), together with the related exemptions thereunder (collectively, Fiduciary Rule). The court invalidated the Fiduciary Rule in its entirety.
There were multiple bases for the Fifth Circuit’s holding
- The Fiduciary Rule, which reflects a “novel interpretation” that took the DOL “forty years to ‘discover,” is not a “reasonable” reinterpretation of the statute, and is an impermissibly “arbitrary and capricious” exercise of administrative power under the Administrative Procedure Act.
- The Fiduciary Rule conflicts with the text of ERISA’s “investment advice fiduciary” provision and is inconsistent with the entirety of ERISA’s fiduciary definition. The DOL “lacked statutory authority to promulgate the Fiduciary Rule with its overreaching definition.”
Various attempts to revive the Fiduciary Rule have failed and neither the DOL nor the Department of Justice have appealed the decision to the Supreme Court.
Federal court denies “Fiduciary exception” challenge to attorney-client privilege in connection with section 36(b) excessive fee lawsuit
On May 17, 2018, the U.S. District Court for the Central District of California denied a motion to compel production of mutual fund independent trustees’ attorney-client privileged documents, in connection with the Section 36(b) lawsuit, Kermis v. Metropolitan West Asset Management, LLC.
The court concluded that the fiduciary exception courts have recognized in contexts such as ERISA litigation does not extend to the attorney-client privileged communications made between the fund’s independent trustees and their independent counsel.
SEC proposes amendments to auditor independence rule to address the “Loan provision”
On May 2, 2018, the SEC voted unanimously to propose amendments to Rule 2-01 (c)( 1 )(ii)(A) under Regulation S-X - the so-called “Loan Provision” (Proposal). Generally, the Loan Provision, as currently in force, provides that an audit firm will not be considered independent from an audit client under Regulation S-X if the audit firm or certain personnel of the audit firm has a lending relationship with a person that owns, beneficially or of record, more than 10per cent of the equity securities of the audit client. “Audit client” is defined to include affiliates of the audit client, which, for a mutual fund, includes all entities within the “investment company complex,” regardless of whether the audit firm actually provides audit services to those other entities. The 10per cent equity ownership threshold would be replaced with a more subjective “significant influence” test that will provide relief for audit firms.
SEC proposes changes to liquidity risk management-related disclosure requirements
Recently, the SEC proposed to eliminate or modify certain disclosure requirements relating to mutual funds' liquidity risk management. Rule 22e-4 (the Liquidity Rule) under the Investment Company Act of 1940 requires a fund to classify each of its investments into one of four liquidity “buckets.” Reporting requirements scheduled to take effect in 2019 for “large” fund groups (and 2020 for “small” fund groups) require funds to publicly report on Form N- PORT the aggregate percentage of their portfolio investments allocated to each of the four liquidity buckets. The proposal would eliminate this public reporting requirement, and replace it with a new requirement to include a narrative-style discussion in a fund's annual shareholder report about the “operation and effectiveness” of the fund's liquidity risk management program during the period covered by the report.
Although the SEC has not prescribed specific information to be included in the discussion, the SEC has noted that the new discussion “should provide investors with enough detail to appreciate the manner in which a fund manages its liquidity risk,” and suggests as examples that a fund may “opt to discuss the particular liquidity risks that it faced over the year, such as significant redemptions, changes in the overall market liquidity of the investments the fund holds, or other liquidity risks, and explain how those risks were managed and addressed, and whether those risks affected fund performance.” The proposal would also add a new reporting requirement to Form N-PORT, requiring a fund to report its cash holdings and certain cash equivalents.
Yahoo’s successor settles first-ever case involving SEC charges for failing to disclose a cybersecurity incident
Recently, Altaba, formerly known as Yahoo, entered into a settlement with the SEC, pursuant to which Altaba agreed to pay $35 million to resolve allegations that Yahoo violated federal securities laws in connection with the disclosure of a 2014 data breach of its user database. The case represents the first time a public company has been charged by the SEC for failing to adequately disclose a cyber breach, an area that is expected to face continued heightened scrutiny as enforcement authorities and the public are increasingly focused on the actions taken by companies in response to such incidents. Altaba’s settlement with the SEC, coming on the heels of its agreement to pay $80 million to civil class action plaintiffs alleging similar disclosure violations, underscores the increasing potential legal exposure for companies based on failing to properly disclose cybersecurity risks and incidents.
SEC settles with private funds for rule 204(b)-1 disclosure violations
On June 1, 2018, the SEC issued a press release announcing settlements for $75,000 each with 13 private fund advisors for violating their disclosure obligations under Rule 204(b)-1 under the Investment Advisers Act of 1940. Rule 204(b)-1, adopted to increase transparency and requires that SEC-registered investment advisers with at least $150 million in private fund assets under management file Form PF with the SEC. According to the SEC, many private fund investment advisers routinely fail to file Form PF annually.
Lorenzo v. SEC and the possible curtailment of 10b-5
In June, the U.S. Supreme Court granted a writ of certiorari in Lorenzo v. SEC, a case where Francis Lorenzo, a registered representative of a broker-dealer allegedly emailed false and misleading statements to investors that were originally drafted by his boss. After SEC findings of liability, a divided panel of the D.C. Circuit determined that, while Lorenzo was not the “maker” of the statements, he did use them to deceive investors, and thereby violated the so-called scheme liability provisions of Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder. As described in the petitioner’s motion seeking certiorari, the case presents the question whether, under the Court’s 2011 Janus Capital Group, Inc. v. First Derivative Traders decision, the scheme liability provisions of Rule 10b-5 may be used to find liability in connection with false or misleading statements by persons who are not themselves the maker of those statements, and thus, not liable under the false-and-misleading statements provision of Rule 10b-5. The answer to this question could have implications for the SEC’s Enforcement Division, as well as potentially significant implications for private securities litigants who principally rely on Section 10(b) to bring private causes of action based on fraud.
Legg Mason to pay $34 Million for violating the FCPA
The SEC announced on August 27, 2018 that Legg Mason Inc. will pay over $34 million to resolve an SEC charge that the company violated the Foreign Corrupt Practices Act (FCPA) in a scheme to bribe Libyan government officials.
According to the SEC’s order, between 2004 and 2010, a former Legg Mason asset management subsidiary, Permal Group Inc., partnered with a French financial services company to solicit investment business from Libyan state-owned financial institutions. These entities engaged in a scheme to pay bribes to Libyan government officials through a Libyan middleman in order to secure investments. As a result of the corrupt scheme, Legg Mason, through its Permal subsidiary, was awarded business tied to $1 billion of investments for the Libyan financial institutions, earning net revenues of approximately $31.6 million.
The SEC’s order finds that Legg Mason violated the internal accounting controls provision of the Securities Exchange Act of 1934. Legg Mason agreed to disgorge approximately $27.6 million of ill- gotten gains plus $6.9 million in prejudgment interest to settle the SEC’s case. Legg Mason had also previously agreed to pay $33 million to the U.S. Department of Justice in sanctions resulting from the firm’s involvement in the Libyan bribery scheme.
Transamerica to pay $97 million to investors relating to errors in quantitative investment models
The SEC announced charges against four Transamerica entities for misconduct involving faulty investment models and ordered the entities to refund $97 million to misled retail investors.
According to the SEC’s order, investors put billions of dollars into mutual funds and strategies using the faulty models developed by investment adviser, AEGON USA Investment Management LLC (AUIM). AUIM, its affiliated investment advisers, Transamerica Asset Management Inc. (TAM) and Transamerica Financial Advisors Inc., and its affiliated broker-dealer Transamerica Capital Inc., claimed that investment decisions would be based on AUlM’s quantitative models. The SEC’s order finds that the models, which were developed solely by an inexperienced, junior AUIM analyst, contained numerous errors, and did not work as promised. The SEC found that when AUIM and TAM learned about the errors, they stopped using the models without telling investors or disclosing the errors.
Without admitting or denying the SEC’s findings, the four Transamerica entities agreed to settle the SEC’s charges and pay nearly $53.3 million in disgorgement, $8 million in interest, and a $36.3 million penalty, and will create and administer a fair fund to distribute the entire $97.6 million to affected investors.
U.S. supreme court holds SEC’s past hiring of administrative judges unconstitutional
On June 21, 2018, Supreme Court issued a decision in Lucia v. SEC, Dkt. No. 17-130, holding that the SEC’s previous practice in hiring administrative law judges (ALJs) was unconstitutional—calling into question the validity of the proceedings and holdings of SEC ALJs that decide the vast majority of contested SEC enforcement actions. With this decision, the Court resolved an outstanding circuit split as to whether SEC ALJs are “officers” of the United States under the US Constitution subject to the requirement of the Appointments Clause that all such officers be appointed by the President, “courts of law,” or “heads of department.” The Court concluded that ALJs are “officers” who must be appointed pursuant to the Appointments Clause but, in doing so, declined to address a number of open questions that follow from this very important decision.
The decision in Lucia leaves a number of questions unanswered. First, the Court declined to address the question of how either the SEC or other prior litigants in front of its ALJs should proceed. The Court expressly declined to decide whether the SEC’s attempt to “ratify” the appointment of its ALJs in November of 2017 successfully cured the constitutional problem. As a result, it remains unclear whether the SEC’s current ALJs occupy those posts constitutionally, or whether additional remedial action by the SEC is necessary (for instance, the SEC could now formally appoint the current ALJs going forward, as opposed to the prior ratification). Separately, the Court also declined to decide what, if any, remedy is available to litigants who did not make a “timely challenge” to the constitutionality of their proceedings. For some litigants—including those who failed to raise the issue and have now exhausted the time for appeal—the Lucia decision likely offers little in the way of relief. For others—namely, those who properly raised a challenge prior to the SEC’s “ratification” and who still have a pending appeal—the decision may offer some relief, depending on whether and how the SEC is able to cure the constitutional issue. The SEC estimates that there are 106 cases for which an ALJ has already issued an initial decision at the time of the SEC ratification order—for whom the import of the Lucia decision is unclear.
Furthermore, it is not clear whether, or to what extent, the Lucia decision will affect the other 36 administrative agencies that use a comparable process to hire ALJs that are then vested with adjudicatory powers similar to those at issue in Lucia. There are about 1,400 ALJs in 36 federal administrative agencies who hear about 700,000 cases each year. Both the parties and the Court expressed sometimes-conflicting views as to the effect of the Lucia decision on other administrative agencies, and the opinion provides no insight as to the expected scope of the holding. These questions have the potential to generate substantial uncertainty for administrative proceedings in the near term.