Monthly Archives: April 2013

Recent Comments Blast SEC and Foreshadow Rule 506 Amendment Delays

Earlier this month Luis Aguilar, a Commissioner at the Securities and Exchange Commission (“SEC”), gave a speech at the Regulatory Compliance Association’s 2013 program on regulations, operations and compliance.  While the views expressed were Mr. Aguilar’s alone, and do not necessarily reflect the views of the SEC, Mr. Aguilar discussed, among other things, the importance of compliance practices being developed and maintained in the interest of investors.  To this end, Mr. Aguilar criticized the SEC’s recent proposal to amend Rule 506 of the Securities Act of 1933 (the “Act”), stating he was “disappointed” in the Commission and had “never seen a more aggressive effort to exclude pro-investor initiatives.”

Rule 506 is one of three exemptive rules for limited offerings under Regulation D of the Act permitting the sale of unregistered securities to an unlimited number of accredited investors and up to 35 non-accredited investors, so long as there is no general solicitation, and as long as appropriate resale limitations are imposed.  Section 201(a)(1) of the Jumpstart Our Business Startups Act (the “JOBS Act”) directs the SEC to amend Rule 506 to allow for general solicitation, provided that all purchasers of the securities are accredited investors.  Originally, these amendments were to be implemented in July of 2012.  The SEC delayed rule-making at that time, however, and on two separate occasions since, the Commission has not set a new deadline on when these amendments will take effect.   Additionally, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) mandates that Rule 506 must be amended to prevent so-called “bad actors” (i.e., felons and other law-breakers) from utilizing this rule, in an attempt to provide additional investor protection.  Congress had directed the SEC to institute this disqualification nearly two years before the JOBS Act had called for the lift on general solicitation, but again the SEC has failed to make such changes.

According to Mr. Aguilar, he recently voted “no” on the most recent proposal by the SEC that would amend the general solicitation aspect of Rule 506, finding it to be “fatally flawed” and “ignor[ing] the recommendations by investors and other regulators.”  Additionally, Mr. Aguilar expressed his disappointment in the SEC’s “apparent lack of urgency” in implementing the “bad actor” amendments to Rule 506.  In his opinion, such provisions are “much needed investor protections” and their delay “only hurts investors.”  These comments imply that final amendments to Rule 506 are not to be expected in the immediate future.  In fact, in Mr. Aguilar’s opinion, the entire amendment structure should be “re-proposed” in order to “adequately address investor protection issues.”

For further information about this, or other related topics, please contact us at (619) 298-2880, or at info@jackolg.com.

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The SEC and CFTC Jointly Approve New Identity Theft Rules

Recently, the Securities and Exchange Commission (“SEC”), in tandem with the Commodity Futures Trading Commission (CFTC), jointly adopted Final Rules requiring certain entities to implement programs to detect red flags and prevent identity theft.  These rules were developed in response to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) which shifted responsibility for identify theft rules and enforcement of such rules from the Federal Trade Commission to the SEC and the CFTC for those entities under their respective jurisdiction.  Specifically, the SEC’s rules will apply to those entities under its jurisdiction, including broker-dealers, investment companies, and investment advisers; while the CFTC’s rules will apply to futures commission merchants, commodity trading advisors and commodity pool operators.  However, both the SEC and CFTC rules will only apply to “financial institutions” and “creditors” as those terms are defined in the Fair Credit Reporting Act that offer and maintain “covered accounts.”

The new rules require those covered entities to develop and implement written policies and procedures designed to detect, prevent and mitigate identity theft in connection with certain existing accounts or the opening of new accounts.  Specifically, these policies and procedures must: (1) identify relevant red flags; (2) detect the red flags; (3) respond appropriately to red flags that have been detected; and (4) periodically update the identity theft policies and procedures.  The Final Rules provide additional guidance, including examples, to help determine which entities qualify and, if so, how to comply with the new rules.

The new rules also require that covered entities provide staff training and appoint a “senior management employee” (most likely the entity’s Chief Compliance Officer) to be responsible for the program.  Furthermore, those entities not initially subject to the new rules are required to periodically reassess whether or not they are required to develop such policies and procedures in light of changes in the accounts they offer or maintain.

The Final Rules will become effective 30 days after publication in the Federal Register.  Once effective, those subject to the new rules will have six months to implement their red flag programs.

For further information about this, or other related topics, please contact us at (619) 298-2880 or at info@jackolg.com.

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Remember, It’s Not Just What You Say, But How and Where You Say It

Recently, the Securities and Exchange Commission (“SEC”) issued an Order Instituting Administrative and Cease-and-Desist Proceedings against ZPR Investment Management, Inc. (“ZPR”) and Max E. Zavanelli (“Zavanelli”) alleging that ZPR and Zavanelli made false and misleading advertisements in several financial magazines and in monthly newsletters to clients and prospective clients.  The SEC goes on to specify that ZPR, through Zavanelli, omitted material information about the firm’s historical performance results (specifically that their period to date performance was underperforming its benchmark index) and claimed compliance with Global Investment Performance Standards (“GIPS Standards”) when in fact they were not in compliance.  If convicted, ZPR and Zavanelli face civil penalties, cease-and-desist orders, and other remedial actions.  This case is an important reminder that although the rules governing advertising by investment advisers are sometimes difficult to navigate, compliance with such rules is mandatory and regularly enforced by the SEC.

Section 206 and Rule 206(4)-1 of the Investment Advisers Act of 1940 (the “Advisers Act”), give statutory guidance on advertising regulations.  Section 206 provides for the general anti-fraud provision of the Advisers Act, which applies to all investment advisers, whether registered with the SEC or not.  Additionally, Rule 206(4)-1, commonly referred to as the “Advertising Rule,” defines certain types of advertisements by investment advisers as fraudulent, deceptive or manipulative, which provides the basic legal framework for investment advisory advertising standards.  However, the brevity of the Advertising Rule should not be viewed casually, for most advertising governance is regulated through no-action letters, enforcement actions and deficiency letters provided to advisers through the SEC’s examination process.  For an in depth discussion on the rules governing advertisements for investment advisers, please see Investment Adviser Performance Marketing and Advertising – What You Need to Know.

Further complicating compliance with advertising rules is the broad definition of what constitutes an “advertisement.”  According to Rule 206(4)-1, an advertisement is any “….notice, circular, letter or other written communication addressed to more than one person…..”  As such, any materials posted via a website, blog, newsletter or social media outlet (i.e., Facebook, LinkedIn, etc.) can constitute an advertisement, and must be in compliance with SEC regulations.  Often advisers find themselves in trouble with the SEC for items they didn’t realize were advertisements to begin with.  Therefore, it is very important that you understand not only what can be communicated to clients and/or prospective clients, but also what communications are considered advertisements and subject to SEC review. 

For further information about this, or other related topics, please contact us at (619) 298-2880 or at info@jackolg.com.

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Custody of Client Accounts: Does “Screen Sharing” Give Rise to a Custody Claim?

According to Rule 206(4)-2 of the Investment Advisers Act of 1940 (the “Act”), the Securities and Exchange Commission (“SEC”) defines “custody” as “…holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.”  This definition gives a broad interpretation as to what constitutes custody, and leaves several grey areas for advisers to try to elucidate.  Recently Charles Schwab published an article on one such area, stating that advisers who have access and login credentials to their client’s online accounts are generally deemed to have custody, if the custodian’s website permits the withdrawal and transfer of funds (regardless of whether the adviser is making such transfers or if the client allowed/disallowed such activities). In taking this a step further, what would be the outcome if an adviser did not have a client’s login credentials, but did the adviser utilize a “screen sharing” application, whereby both the client and the adviser have the ability to view the client’s online account, and each have access to make withdrawals/transfers to that account simultaneously?

While the SEC has not specifically addressed this practice in its Custody FAQs, consider the similar application of how may custody apply in the situation whereby the adviser is given hard copy statements of assets held away from the adviser, and the client requests guidance on their portfolio holdings.  In this case, the adviser would not be deemed to have custody since the adviser, “did not have the ability to withdraw [or transfer] funds”[1] away from the client’s account.

Conversely, should login credentials be provided to the adviser in order for the adviser to view the client’s account in order to provide similar adviser, it could be construed that the adviser is deemed to have custody, for then the adviser would have the ability to withdraw funds from a client’s online account.  This is a key differential that should be considered. In its FAQ, the SEC goes on to state that whether an adviser does or does not have the client’s authority to withdraw or transfer assets of such accounts is irrelevant.  The mere fact that the adviser has the ability to make such changes is the focal point.  As such, in a screen sharing scenario, if the adviser has the ability to make a withdrawal or transfer client funds, this would likely be deemed as having custody for purposes of Rule 206(4)-2 of the Act, subjecting the adviser to the reporting and auditing requirements therein.

For further information on this, or other related topics, please contact us at info@jackolg.com or (619)298-2880.

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