Advisers Act Regulatory Series - Eversheds Sutherland · 2020. 6. 25. · Proposed Form CRS...

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Second Quarter UpdateAdvisers Act Regulatory Series

May 24, 2018

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

Eversheds Sutherland

Advisers Act Regulatory Series

SpeakersSecond Quarter Update

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

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

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

Ben MarzoukWashington DC+1 202 383 [email protected]

Bria AdamsWashington DC+1 202 383 [email protected]

Sue LeeNew York, NY+1 212 389 [email protected]


Today’s Discussion:


─ The SEC’s Proposed Fiduciary Duty Interpretation and Form CRS Relationship Summary

─ OCIE’s Risk Alert on Advisory Fees and Expenses

─ Exam and Enforcement Trends: The SEC’s 12b-1 Share Class Selection Disclosure Initiative and Other Developments

─ FinCEN’s Customer Due Diligence FAQs

─ FINRA’s OBA/PST Rule Proposal and Implications for Broker-Dealer Supervision of Advisory Activity

─ Performance Advertising – Recent Developments

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The SEC’s Proposed Fiduciary Duty Interpretation – What Just Happened?


─ On April 18, in a 4-1 vote, the United States Securities and Exchange Commission (the SEC) proposed a comprehensive set of reforms governing the fiduciary duty and standard of conduct applicable to broker-dealers and investment advisers who provide retail investment advice. The proposed rules would: • Require broker-dealers and investment advisers to summarize their relationship to

retail investors; • Establish a broker-dealer best interest standard of conduct; • Restrict the use of the term “adviser” or “advisor” by broker-dealers; and • Require investment advisers to adhere to certain conduct as fiduciaries

─ The reform package comprises three parts:• A Broker-Dealer Standard of Conduct (Regulation Best Interest);• New Disclosures and Titling Requirements for Broker-Dealers, Advisers and Dual

Registrants (the Form CRS Relationship Disclosure); and • Proposed Commission Interpretation Regarding Standard of Conduct for Investment

Advisers and a Request for Comment on Enhancing Investment Adviser Regulation

─ 90-day comment period on all proposals closes August 7, 2018

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The SEC’s Proposed Fiduciary Duty InterpretationSecond Quarter UpdateAdvisers Act Regulatory Series

How Is the Proposed Interpretation for Advisers Different From the Fiduciary Standard That Exists Today?

─ “Reaffirm(s)—and in some cases clarifies—certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.”

─ The interpretation notes that SEC-registered investment advisers are subject to a duty of care and a duty of loyalty and that the fiduciary duty requires each adviser, at all times, to serve the best interest of its clients and not subordinate its clients’ interest to its own.

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The SEC’s Proposed Fiduciary Duty InterpretationSecond Quarter UpdateAdvisers Act Regulatory Series

What other new obligations is the SEC considering for investment advisers?

─ Federal licensing and continuing education

─ Account statements

─ Financial responsibility requirements

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Proposed Form CRS Relationship Summary Second Quarter UpdateAdvisers Act Regulatory Series

─ What information will broker-dealers and investment advisers have to disclose to customers/clients?• Introduction • Relationships and Services• Standard of Conduct• Summary of Fees and Costs• Comparisons• Conflicts of Interest• Additional Information • Key Questions

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─ Presentation and format• Highly standardized

• Must use certain specified phrasing and formatting (e.g., tables)

• Cannot include disclosures outside of the four corners of the instructions

• Must respond to each item and provide responses in the same order as the items appear in the instructions

• Four-page limit

• Different requirements depending on whether entity is a standalone broker-dealer, standalone investment adviser or dual registrant

• Three mock-ups provided, but they are not a safe harbor

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─ “Layered” approach to disclosure

• Intent is for Form CRS to be a “high-level” document designed to make clear to investors the capacity in which the financial professional is acting

• If delivered on paper and not as a standalone document, registrant should ensure that it is the first among any documents delivered at that time

• Concept borrows from mutual fund summary prospectus regime

• Registrants are required to include cross-references in Form CRS regarding where additional information can be found

• Electronic versions of Form CRS must contain hyperlinks to cross-referenced disclosures

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─ Delivery requirements• Must deliver to “retail investors” – not “retail customers”

• Different scope from Reg. BI – see Footnote 29 of the CRS Release for the SEC’s explanation for the difference

• Transition period – obligation to deliver first Form CRS to all existing clients who are retail investors

• Delivery obligations upon material changes to form

• Delivery obligations to new customers/clients

• Delivery obligations to existing customers/clients

• E-delivery permitted

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─ Filing requirements

• Where to file

• Varies by type of registrant (i.e., standalone broker-dealer, standalone investment adviser or dual registrant)

• Timing

• Updating

─ Must also post on firm website

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─ Item 3: Standard of Conduct

• Comparing the required language – BD vs. IA

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Only applies when a recommendation is made

Must tell, but not required to be in a way investor can understand?

Applies to entire relationship

Must tell in a way that investor can understand

Client consent to conflict

Second Quarter Update

Proposed Form CRS Relationship Summary



─ Item 6: Conflicts of Interest

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─ These instructions apply to all registrants

─ Only required to briefly describe these particular conflicts, and no others, in keeping with layered approach to disclosure

─ “Examples of investments” are limited to product type (e.g., “mutual funds and variable annuities”) and do not have to be exhaustive

Second Quarter UpdateProposed Form CRS Relationship Summary


OCIE’s Risk Alert on Advisory Fees and Expenses


─ The Risk Alert was issued by the SEC’s Office of Compliance, Inspections and Examinations in April 2018

─ Reflects issues identified in deficiency letters from over 1,500 adviser examinations over the past two years

─ Notes two actions against advisers in 2017

─ Covers six areas of most frequent advisory fee and expense compliance issues• Fee billing based on incorrect account valuations• Billing fees in advance or with improper frequency• Applying incorrect fee rates• Adviser expense misallocations• Omitting rebates and applying discounts incorrectly• Disclosure issues involving advisory fees

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─ Fee billing based on incorrect account valuations• Observations

• Valuing clients’ accounts using a different metric from that which is outlined in the advisory agreement

• Valuation of illiquid assets using original cost versus FMV• Valuing clients’ accounts using a process that differs from the process

outlined in the advisory agreement• Market value at the end of the billing cycle versus average daily balance of

account assets• Assets excluded for purposes of the fee calculation

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─ Billing fees in advance or with improper frequency• Frequency of fees inconsistent with advisory agreement and

Form ADV• Billing in advance, despite the advisory agreement stating that

the client would be billed in arrears• Failure to pro-rate fees for clients whose advisory services began

mid-billing cycle• Failure to reimburse clients whose advisory services ended mid-

billing cycle, as outlined in the Form ADV

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─ Applying incorrect fee rates• Charging a higher fee rate than agreed upon in the advisory

agreement or double-billing clients• Charging non-qualified clients performance fees based on a

percentage of capital gains

─ Adviser expense misallocations• Allocating of distribution and marketing, regulatory filing fees,

and travel expenses to clients

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─ Omitting rebates and applying discounts incorrectly• Failing to aggregate client account values for households, as

described in the advisory agreement of Form ADV• Failing to reduce a client’s fee rate when the client’s account

value reached a certain level, as described in the advisory agreement of Form ADV

• Charging client’s brokerage fees for transactions that qualify under a wrap fee program

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─ Disclosure issues involving advisory fees• Engaging in business practices that are inconsistent with

disclosures in Form ADV• Client advisory fees exceeding maximum fees stated in Form ADV

• Failing to disclose additional fees or markups in addition to advisory services

• Collecting expenses in excess of actual fees• Earning additional compensation or participating in fee sharing

arrangements

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Exam and Enforcement Trends


─ Share Class Selection Disclosure Initiative (Feb. 12, 2018)• SEC’s Division of Enforcement “will agree not to recommend financial penalties

against advisers who self-report violations of the federal securities laws relating to certain mutual fund share class selection issues and promptly return money to harmed clients”

• “The Division warns that it expects to recommend stronger sanctions in any future actions against investment advisers that engaged in the misconduct but failed to take advantage of this initiative”

• Advisers already contacted by the Division of Enforcement regarding possible violations relating to share class selection are not eligible for this self-reporting

• However, advisers that are subject to pending exams by OCIE relating to this issue, but which have not been contacted by Enforcement, are eligible to participate

• Must self-report by June 12, 2018, to be eligible for the initiative• Must complete a questionnaire and an accompanying spreadsheet requesting data

about the 12b-1 fees received, and other information

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─ Share Class Selection Disclosure Initiative – Division of Enforcement FAQs (May 1, 2018)• FAQ #2 – Makes clear that the SCSD initiative does not apply to

receipt of fees other than 12b-1 fees – e.g., sub-TA fees, revenue sharing, etc.

• FAQ #4 – No matter the scope or severity of the conduct, all self-reporting advisers receive the standardized settlement terms

• FAQs #9 and #11 – Guidance for firms who are evaluating their share class exposure and whether to self-report

• FAQ #9 – What constitutes disclosure sufficient to avoid an enforcement action?• FAQ #11 – When is a lower-cost share class of the same fund “available”?

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─ Three recent share class suitability cases• Geneos Wealth Management, Inc. (Apr. 6, 2018)• Securities America Advisors, Inc. (Apr. 6, 2018)• PNC Investments LLC (Apr. 6, 2018)

─ Basis for enforcement actions• Failure to adequately disclose conflicts associated with receipt of

12b-1 fees• “May” disclosures when they were actually receiving the 12b-1 fees• Did not state that the 12b-1 fees created a conflict of interest and that the

adviser would select share classes charging 12b-1 fees even when clients were eligible for lower-cost share classes of the same fund

• Breach of duty to seek best execution• Note that Share Class Selection Disclosure Initiative’s standard settlement

terms do not include this charge. See footnote 3 of the Share Class Selection Disclosure Initiative Announcement

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FinCEN’s Customer Due Diligence Rules


─ AML Due Diligence for Legal Entities

• Rules proposed by the Financial Crimes Enforcement Network (FinCEN) in August 2014

• Adopted in May 2016

• Went into effect on May 11, 2018

• General Rule: Covered financial institutions required to take reasonable steps to identify and verify the “beneficial owners” of “legal entity customers”

• Applies to banks, broker-dealers, mutual funds, futures commission merchants and introducing commodity brokers

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─ AML Due Diligence for Legal Entities

• “Beneficial Ownership”• Two Prongs: Ownership and Control• Ownership: Each individual (i.e., natural person) who, directly or indirectly,

owns 25% or more of a legal entity customer• Control: A single individual (i.e., natural person) with significant

responsibility to manage, control, or direct a legal entity customer• Each prong is an independent test, so firms must identify and verify up to

four natural persons under the ownership prong and one natural person under the control prong

• “Legal Entity Customer”• Corporation, LLC or any other entity formed under US or foreign laws that

opens an account with a covered financial institution• Specific exclusions for investment companies, banks, broker-dealers and

investment advisers

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─ AML Due Diligence for Legal Entities• “Account”

• Follows definition of “account” under CIP rules• Specifically excludes accounts opened for purpose of participating in ERISA

retirement plans

• Impact to Investment Advisers• Not included in definition of a “covered financial institution”• Not included in definition of a “legal entity customer” (ownership

information already exists on Form ADV)• Definition of “legal entity customer” excludes certain pooled investment

vehicles, such as hedge funds and other private funds, operated or advised by SEC registered investment advisers

• Only need to collect control prong (not ownership prong) for pooled vehicles managed by non-SEC registered investment advisers

• May eventually extend to investment advisers

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─ Frequently Asked Questions (Apr. 3, 2018)• Issued prior to effectiveness of new rules• FAQ #18: Pooled investment vehicles

• No requirement to “look through” pooled investment vehicles to identify and verify 25% or more beneficial owners

• Practical considerations related to ownership fluctuations of pooled investment vehicles

• Control prong still needs to be satisfied• FAQ #19: Trusts

• Trust owning 25% or more of legal entity customer• Trustee would be beneficial owner• If multiple trustees, only need to identify one trustee

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─ Frequently Asked Questions (Apr. 3, 2018)• FAQ #7: Existing customers

• If individual identified as the beneficial owner is an existing customer of the financial institution, and has already gone through the financial institution’s CIP, the financial institution may rely on the CIP information to satisfy the identification and verification requirements

• FAQ #10: Legal entity customer with multiple accounts• Legal entity customer opens multiple accounts with a financial institution.• May rely on information provided in certification form for the first account

to fulfill any subsequent accounts opened by the customer• FAQ #17: Updating information

• Risk-related trigger vs. initial identification and verification• Same process applies. For risk-related triggering events, financial

institution must identify and verify in accordance with normal account opening procedures

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─ Recent Developments• FinCEN Administrative Ruling (May 16, 2018)

• 90-day relief to covered financial institutions from complying with new CDD rules

• Relief limited to financial services or products that automatically rollover or renew (e.g., CD and loan accounts) and were established before May 11, 2018

• FinCEN Director Congressional Testimony (May 16, 2018)• Acknowledges new CDD rules are work in progress• Enforcement not primary focus initially• Looking for good-faith compliance effort

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FINRA’s OBA/PST Rule Proposal and Implication for Broker-Dealer Supervision of Advisory Activity


─ FINRA Rule 3290 was proposed on Feb. 26, 2018; Comment period ended on April 27, 2018

─ The proposed rule would require a registered person to provide his or her broker-dealer with prior written notice of all investment-related or other business activities outside the scope of the relationship with the member

─ The proposed rule would define investment-related in the same manner as the Form U-4 • i.e., “pertaining to securities, commodities, banking, insurance, or real estate (including,

but not limited to, acting as or being associated with a broker-dealer, issuer, investment company, investment adviser, futures sponsor, bank, or savings association)”

─ Business activity would be defined as: (1) acting as an employee, independent contractor, sole proprietor, officer, director or partner of another person; or (2) receiving compensation, or having the reasonable expectation of compensation, from any other person as a result of the activity

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Investment-Related Activity

─ Investment-related activity would be subject to more stringent supervisory requirements than that imposed on business activity

─ The proposed rule would require a FINRA member firm to assess the risks of proposed investment-related activity. A member would be required to evaluate whether the proposed activity will: • interfere with or otherwise compromise the registered person’s responsibilities to

member’s customers; or • be viewed by customers or public as part of the member’s business based upon the

nature of the proposed activity and the manner in which it will be offered

─ Based on an evaluation of the investment-related activity, the member would • approve the registered person’s participation; • approve the registered person’s participation subject to conditions or limitations; or• disapprove the registered person’s participation

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Impact on Advisory Activity

─ Investment Advisory activity conducted on behalf of a dually registered firm or an advisory affiliate would be excluded

─ The proposed rule would not impose supervisory and recordkeeping obligations on advisory activities conducted by a third-party, non-affiliated investment adviser

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Advertising No-Action LetterSecond Quarter UpdateAdvisers Act Regulatory Series

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South StateCorporation

South State Bank

Minis & Co.

South State Advisory


Advertising No-Action LetterSecond Quarter UpdateAdvisers Act Regulatory Series

─ Each adviser has its own• management team, which reports separately to an SSB

management team• investment committee, which is responsible for the adviser’s

investment decisions

─ Minis’ business will continue as a separate division of SSA operating under the Minis brand

─ The same management team that currently manages Minis will manage the Minis division after the restructuring

─ The Minis investment committee will continue to be responsible for the Minis division’s investment decisions

─ Staff: Minis division can use the performance track record of Minis to the same extent as it could have used the track record had the restructuring not occurred

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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]

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

Ben MarzoukWashington DC+1 202 383 [email protected]

Bria AdamsWashington DC+1 202 383 [email protected]

Sue LeeNew York, NY+1 212 389 [email protected]

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