Insights from Winston & Strawn
The Securities and Exchange Commission (“SEC”) charged fund administrator Apex Fund Services (US), Inc. (“Apex”), with failure to heed red flags and correct faulty accounting by two clients. Apex is a fund administrator based in New Jersey and a subsidiary of Apex Fund Services Holdings, Ltd., which is registered in Bermuda. Apex served as fund administrator to two separate advisers who were charged with fraud by the SEC. In connection with the investigations of the advisers, the SEC uncovered evidence that Apex missed or ignored clear indications of fraud and thus contributed to the damage caused to investors.
ClearPath Wealth Management, LLC (“ClearPath”), was charged in May 2015 with securities fraud violations relating to its misappropriation scheme involving its four series funds (the “Series Funds”). ClearPath contracted with Apex to provide fund administration services to the Series Funds, and Apex served in this role from December 2011 to December 2012. A key feature of the Series Funds was that each series invested in a single investment and investors were able to select which series they wanted to participating in when subscribing. Each of these Series Funds, pursuant to the limited partnership agreements, was to be treated as a “sub-partnership” and their assets and liabilities were not to be comingled in any way.
The SEC found that Apex did not set up its accounting system in a way that would ensure the Series Fund’s assets and liabilities were allocated to specific sub-partnership. Further, Apex only maintained one bank account for each Series Fund and did not keep the assets of each sub-partnership separate. As a result, the capital account statements generated for ClearPath to distribute to investors did not correctly reflect ClearPath and its president’s use of sub-partnership assets. The SEC alleged that this failing made it possible for ClearPath to misappropriate and use assets for unauthorized investments.
The specific charges against Apex are that (i) Apex ignored red flags and was a cause of ClearPath’s records’ failure to account for a margin loan, (ii) Apex ignored or missed red flags and was a cause of ClearPath’s records’ failure to account for a line of credit, and (iii) Apex failed to account for prohibited inter-series and inter-fund commingling. As a result, Apex was charged with being a cause of ClearPath and its president’s violations of Sections 206(2) and 206(4) of the Investment Advisers Act of 1940, as amended (“Advisers Act”) and Rule 206(4)-8 thereunder. Apex agreed to settle the charges relating to ClearPath by agreeing to retain a compliance consultant, a disgorgement of $96,800, plus $8,813 in interest, and a $75,000 penalty.
In March 2016, the SEC charged EquityStar Capital Management, LLC (“EquityStar”), and its owner with fraud for making materially false and misleading statements to current and prospective investors in two private funds (the “Funds”) they managed and making undisclosed withdrawals directly from the Funds in excess of $1 million. Apex provided accounting and administrative services to the Funds for over two years. In the time it served as administrator, Apex accounted for the withdrawals as assets of the funds (receivables) without obtaining any evidence that EquityStar or its owner were willing or able to repay the money. Therefore, the statements Apex prepared for investors materially overstated the value of the investors’ holdings as the withdrawals were reflected as receivables due to the Funds. After two years of working with the Funds, Apex properly disclosed with withdrawals to the investors; however, by that point, the investors had suffered significant losses.
Further compounding the appearance of negligence on the part of Apex is that in the time it served as administrator, it received multiple warnings from EquityStar’s previous fund administrator alerting Apex to investor complaints and lack of communication with investors by EquityStar. One warning from the prior administrator stated in no uncertain terms that there were “numerous issues that made [EquityStar and its owner] too risky to have as clients.” It was not until they received these warnings in 2013 that Apex did a background check on EquityStar’s owner and discovered his 2007 wire fraud conviction. Even with this information, Apex decided to continue to offer administrator services and send the statements that did not disclose the improper withdrawals.
The SEC found Apex (i) knew, or should have known, that EquityStar’s owner was unwilling or unable to repay the money he withdrew and therefore accounted improperly for it, and (ii) knew or should have known that the monthly statements it sent to investors were materially misleading and significantly overstated the value of investors’ holdings. As a result, Apex was charged with being a cause of EquityStar and its owner’s violations of Sections 206(2) and 206(4) of the Investment Advisers Act of 1940, as amended (“Advisers Act”) and Rule 206(4)-8 thereunder. Apex agreed to settle the charges relating to EquityStar by agreeing to retain a compliance consultant, a disgorgement of $89,050 , plus $7,786 in interest, and a $75,000 penalty.
It should be noted that the SEC, as part of the remedial action in both cases, required Apex to hire an independent compliance consultant to conduct a comprehensive review of, and recommend corrective measures concerning, Apex’s compliance and other policies and procedures with respect to: i) setting up fund administration and accounting to comport with client fund governing documents, ii) ensuring administration and accounting systems correctly account for fund margin or other borrowing, intra-fund borrowing, or other fund transactions, iii) preparing accurate capital account or other fund or investor account statements, iv) communicating with clients, auditors, and others about clients’ possible failure to comport with fund governing documents, and v) detecting and addressing fraud. Apex, with the consultant, is required to make reports of the progress of implementing these policies and procedures, thereby providing a roadmap for a future SEC enforcement action for failure to properly follow its own procedures.
Enforcement actions against service providers to fund managers is not unprecedented, as the SEC brings actions against auditors, and on occasions attorneys, pursuant to Rule of Practice 102(e) to sanction or sometimes bar such persons from the industry. However, these types of enforcement actions remain fairly infrequent. In May 2013, the SEC brought an action against a fund administrator of a mutual fund “series trust” for, among other things, failure to properly evaluate and approve investment management agreements pursuant to Section 15(c) of the Investment Company Act. Whether the Apex action signals a new direction in the enforcement program with respect to hedge fund administrators remains to be seen, but administrators that take direction from fund managers for net asset value calculations and performance reporting to investors should consider themselves to have been put on notice by the SEC with this most recent action. If the standard is that a fund administrator has been put on notice by “red flags” that any fund administrator performing similar duties would have discovered, administrators may be able to point to their contractual arrangement to avoid liability to the fund manager and investors, but it appears that such exculpatory or even mandating language would not be sufficient to avoid an SEC enforcement action.
Feature: D.C. Circuit Rejects States’ Challenge to Regulation A+ Capital Raising Guidelines
Pursuant to the Securities and Exchange Commission’s (“SEC”) capital raising rules under the JOBS Act, the SEC increased the limit on certain offerings to both accredited and non-accredited investors to create even more opportunities for small businesses to raise capital without having to comply with some of the more burdensome features of the traditional registration process. Among other things, Tier II of the new final rules, known as Regulation A+, removed state blue sky review allowing firms issuing securities under Regulation A+ the ability to move forward without requesting approval from each individual state. This preempted states from regulating securities sold to “qualified purchasers,” defined by the SEC as accredited investors or anyone else who limits their purchase to 10% of their annual income or net worth. Before enactment of the JOBS Act, state review effectively shot down the exemption.
In an effort to challenge Regulation A+, petitioners William Galvin and Monica Lindeen, the chief securities regulators for Massachusetts and Montana respectively, filed suit in the D.C. Circuit for the U.S. Court of Appeals. Petitioners argued that the SEC failed to adequately protect investors when it adopted changes to Regulation A of the Securities Act of 1933 by expanding the criteria necessary to participate in Regulation A+ offerings.
Petitioners questioned these amendments, maintaining that the term “qualified purchaser” cannot mean “anyperson” to whom Tier II securities are offered or sold but instead must more broadly limit the universe of purchasers to those with enough financial wealth or sophistication to invest without state law protections. Petitioners further argued that since the SEC “declined to adopt a qualified-purchaser definition limited to investors with sufficient wealth, revenue or financial sophistication to protect their interests without state protection, Regulation A+ fails both parts of the U.S. Supreme Court’s statutory construction standards enunciated in Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc.” Finally, the petitioners argued that the rule “should be vacated as arbitrary and capricious because the SEC failed to explain adequately how it protects investors.”
On June 14th, the D.C. Circuit rejected petitioners’ arguments against Regulation A+. Circuit Judge Karen Henderson wrote that lawmakers “intended the SEC to enjoy broad discretion to decide who may purchase which securities without the encumbrance of state registration and qualification requirements” and properly exercised its discretion to protect the public through a purchase cap and reporting requirements.” Circuit Judge Henderson noted that petitioners are incorrectly interpreting the dictionary definition of “qualified” as meaning that “qualified purchasers” cannot mean “all” Tier-2 purchasers. She added that, when “Congress explicitly authorize[s]” an agency to “define [a] term,” it “necessarily suggests that Congress did not intend the word to be applied in its plain meaning sense … [a]nd when the Congress enacted the [National Securities Markets Improvement Act] and the JOBS Act, it not only gave the SEC authority to determine which purchasers are qualified but it also permitted the SEC to define the term differently for different types of securities offerings.”
On June 15th, Galvin noted his disappointment in the Circuit’s failure to address the damage to the average investor that results from preemption. Galvin suggested that Congress never intended to give the SEC unrestricted discretion to preempt state registration and qualification provisions. Galvin added that “[w]e believe the pendulum will swing back towards investor protection, but I fear it may be too late for investors harmed by the mad rush to deregulate and dismantle securities laws.”
According to Crowdfund Insider, while states may try to challenge this decision, many feel that any further action is now doubtful.
Banking Agency Developments
Agencies Issue Host State Loan-to-Deposit Ratios
On June 17th, the Office of the Comptroller of the Currency (“OCC”), along with the Board of Governors of the Federal Reserve System and the FDIC, issued the host state loan-to-deposit ratios that they will use to determine compliance with Section 109 of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. These ratios replace the prior year’s ratios, which were released on June 29, 2015.
Agencies Release List of Distressed or Underserved Nonmetropolitan Middle-Income Geographies
On June 17th, the OCC, along with the Board of Governors of the Federal Reserve System and the FDIC,announced the availability of the 2016 list of distressed or underserved nonmetropolitan middle-income geographies, where revitalization or stabilization activities will receive Community Reinvestment Act consideration as community development.
OCC Issues Joint Statement on New Accounting Standard on Financial Instruments – Credit Losses
On June 17th, the OCC, along with the Board of Governors of the Federal Reserve System, the FDIC, and the National Credit Union Administration, issued a joint statement in response to the new accounting standard issued by the Financial Accounting Standards Board on June 16, 2016. OCC Bulletin.
OCC Will Be Hosting Credit Risk and Operational Risk Workshops in Florida
On June 15th, the OCC announced that it will host two workshops in Tampa, Fla., at the Holiday Inn Tampa Westshore, July 26-27, for directors of national community banks and federal savings associations supervised by the OCC. The Credit Risk workshop on July 26th will focus on credit risk within the loan portfolio, such as identifying trends and recognizing problems, while the Operational Risk workshop on July 27th will focus on people, processes and systems.
Securities and Exchange Commission
SEC Makes Technical Corrections to Asset-Backed Securities and Registration Rules
On June 16th, the SEC published technical amendments to final rules adopted on September 24, 2016, that revise Regulation AB and other rules governing the offering process, disclosure, and reporting for asset-backed securities. The revised rules correct unintended changes to the rule text, revise outdated cross-references, and implement other technical corrections. The revised rules will become effective upon publication in the Federal Register. SEC Release 33-10099.
SEC Adopts Changes to EDGAR Filer Manual
The SEC adopted final rules on June 13th that implement revisions to the EDGAR filer manual to reflect updates to the EDGAR system, including updates to support the submission of asset-back securities related form types by certain registrants; to eliminate support for the US-GAAP-2014, EXCH-2014, COUNTRY-2012, and CURRENCY-2012 taxonomies; and to permit certain filers to use Inline XBRL in their Related Official Filing under certain conditions. The final rules will be effective upon publication in the Federal Register. SEC Release No. 33-10095.
SEC Proposes Revised Disclosures for Mining Properties
The SEC proposed rules on June 16th that would modernize the disclosure requirements for mining properties under Regulation S-K. The proposed rules would align the disclosure requirements with current industry and global regulatory practices and standards by establishing a single standard requiring registrants to disclose mining operations that are material to the company's business or financial condition; requiring the disclosure of mineral resources and material exploration results; and requiring disclosures to be prepared by a "qualified person," among other things. The proposed rules would also rescind Industry Guide 7 and include the mining property disclosure requirements in a new subpart of Regulation S-K. Comments should be submitted within 60 days of publication in the Federal Register. SEC Press Release.
SEC Exemption Will Allow Companies to File Using Inline XBRL
The SEC issued an order on June 13th that grants a limited and conditional exemption to companies from Securities Exchange Act requirements to attach an exhibit containing the required XBRL structured data to their annual and quarterly reports. Companies may now use Inline XBRL format to integrate the required XBRL data within their HTML filings through March 2020. The use of Inline XBRL by companies is voluntary, but companies choosing to use the format must abide by certain requirements to qualify for the exemption. SEC Press Release.
Speeches and Statements
White Asks Senate Banking Committee for Support, Receives Rebuke
SEC Chair Mary Jo White testified before the Senate Committee on Banking, Housing, and Urban Affairs on June 14th regarding the SEC’s current work and initiatives. White highlighted the SEC’s work on equity market structure, mutual and exchange-traded funds, small business capital formation, the regulation of security-based swaps, and disclosure effectiveness, requesting that the Committee support the SEC in the face of proposed budget cuts. According to Reuters, White faced sharp questioning from Senator Elizabeth Warren, who expressed disappointment at the SEC’s disclosure review and White’s leadership, as well as from Senator Chuck Schumer, who objected to the SEC’s inaction on political disclosure rules for public companies. White Testimony.
Equity Market Structure Advisory Committee Meeting
The SEC announced that its Equity Market Structure Advisory Committee will meet by telephone on July 8th to consider a recommendation for an access fee pilot, recommendations related to trading venues regulation, and presentations by the Regulation NMS and Trading Venues Regulations subcommittee chairs. Written statements should be submitted on or before July 5, 2016. SEC Release No. 34-78040.
SIPC Proposes Bylaw Amendments Relating to Assessments
The SEC provided notice on June 15th of proposed bylaw amendments filed by the Securities Investor Protection Corporation (“SIPC”) that would modify its Assessments Bylaw by imposing an intermediary assessment rate and amending the date on which any change in assessments becomes effective. Under the proposed amendments, the intermediary assessment rate would apply when the SIPC Fund’s balance is expected to be $2.5 billion for at least six months but its unrestricted net assets are less than $2.5 billion. Comments should be submitted within 21 days of publication in the Federal Register. SEC Release No. SIPA-177.
Money Market Fund Statistics
On June 14th, the SEC’s Division of Investment Management released updated Money Market Fund Statisticswith data as of April 30, 2016.
SEC Approves Adjustments to Dollar Amount Tests for Performance Advisory Fees
The SEC issued an order on June 14th approving adjustments to the dollar amount thresholds of the asset-under-management test and the net worth test for determining client performance fees charged to “qualified clients.” Effective August 15, 2016, the dollar amount of the assets-under-management test will be set at $1,000,000, and the dollar amount of the net worth test will be set at $2,100,000. SEC Release No. IA-4421.
On June 13th, the SEC published the EDGAR Filer Manual Volume II, which includes instructions for formatting and attaching Inline XBRL documents to EDGAR submissions, and EDGAR Form N-MFP1 XML Technical Specification (Version 1.1).
Commodity Futures Trading Commission
CFTC’s Market Risk Advisory Committee Announces Agenda for June 27th Public Meeting
On June 16th, the U.S. Commodity Futures Trading Commission (“CFTC”) announced the agenda for the upcoming Market Risk Advisory Committee (“MRAC”) public meeting that will be held on June 27, 2016 at CFTC’s headquarters in Washington, D.C. The MRAC will discuss the CCP Risk Management Subcommittee’s draft recommendations on how Central Counterparties (“CCPs”) can better coordinate their efforts in preparing for the default of a significant clearing member, and the role of the FDIC and CFTC in the resolution of both banks and CCPs.
CFTC Reopens Comment Period for Certain Elements of Regulation AT
On June 16th, the CFTC announced that it has reopened the comment period for its notice of proposed rulemaking on Regulation AT from June 10, 2016 through June 24, 2016 to accept comments on items in the Roundtable and Comment Period Discussion Points, the roundtable agenda, and issues that arose during the public roundtable that it held on June 10th regarding Regulation Automated Trading (“Regulation AT”).
Proposed Clearing Requirement Rule Is Published in the Federal Register
On June 16th, the CFTC’s proposal to establish a new clearing requirement under the Commodity Exchange Act (“CEA”) was published in the Federal Register. The amended regulation would require that interest rate swaps denominated in certain currencies or having certain termination dates be submitted for clearing by those required to do so under the appropriate section of the CEA to a derivatives clearing organization (“DCO”) that is registered under the CEA or a DCO that has been exempted from registration under the CEA. Comments must be received by July 18, 2016.
CFTC Requests Public Comment on a Rule Amendment Certification Filing by ICE Futures U.S
On June 14th, the CFTC requested public comment on a rule amendment certification filing by ICE Futures U.S., which would clarify that parties to a block trade may engage in pre-hedging or anticipatory hedging of the position that they believe in good faith will result from the consummation of the block trade, except for an intermediary that takes the opposite side of its own customer order. Comments must be submitted on or before July 14, 2016.
CFTC Approves Final Rule to Amend Swap Data Recordkeeping and Reporting Requirements for Cleared Swaps
On June 14th, the CFTC announced that it has approved a final rule amending existing swaps reporting regulations in order to provide additional clarity to swap counterparties and registered entities regarding their reporting obligations for cleared swap transactions, and to improve the efficiency of data collection and maintenance associated with the reporting of the swaps involved in a cleared swap transaction. The final rule will become effective 180 days following publication in the Federal Register. Chairman Massad Statement.
CFTC Proposes Certain Exemptions and Guidance on Position Limits for Derivatives
On June 13th, the CFTC proposed new alternative processes for designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) to recognize certain positions in commodity derivative contracts as nonenumerated bona fide hedges or enumerated anticipatory bona fide hedges, as well as to exempt from federal position limits certain spread positions. The CFTC also proposed to further amend certain relevant definitions, including to clearly define the general definition of bona fide hedging for physical commodities under the standards in CEA section 4a(c). The CFTC separately proposed to delay for DCMs and SEFs that lack access to sufficient swap position information the requirement to establish and monitor position limits on swaps. Comments must be received on or before July 13, 2016.
CFTC Extends No-Action Relief to SEFs and DCMs from Certain CFTC Regulations for Correction of Errors
On June 10th, the CFTC’s Division of Market Oversight (“DMO”) and Division of Clearing and Risk announced a no-action letter extending relief from certain CFTC regulations to permit SEFs and DCMs to correct clerical or operational errors that caused a swap to be rejected for clearing and become void. The no-action letter also permits SEFs and DCMs to correct clerical or operational errors discovered after a swap has been cleared.
Federal Rules Effective Dates
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Exchanges and Self-Regulatory Organizations
Depository Trust Company
DTC Proposes Link with Euroclear Bank to Facilitate the Use of Securities in Collateral Transactions
On June 10th, the SEC requested comments on a proposed rule change filed by the Depository Trust Company (“DTC”) that would add a new rule to establish a link between DTC and Euroclear Bank SA/NV for DTC Participants that are also Euroclear Bank participants to use securities held at DTC for Euroclear Bank Collateral Transactions. Comments should be submitted on or before July 7, 2016. SEC Release No. 34-78031.
Financial Industry Regulatory Authority
SEC Seeks Comments on Amendment to FINRA’s Proposed Margin Requirements for Covered Agency Transactions
On June 15th, the SEC issued an order granting accelerated approval to the Financial Industry Regulatory Authority’s (“FINRA”) proposed rule change that would establish margin requirements for covered agency transactions. The SEC also requested comment on FINRA’s amendment to the proposal, which increases the specified amount for the gross open position exception from $2.5 million or less in aggregate to $10 million and clarifies the effective date for certain provisions related to risk limit determinations. Comments on the amendment should be submitted within 21 days of publication in the Federal Register. SEC Release 34-78081.
Former SEC Director Will Serve as FINRA’s CEO
FINRA announced on June 13th that Robert W. Cook will succeed Richard G. Ketchum as FINRA’s CEO. Cook previously served as the Director of the SEC’s Division of Trading and Markets. The transition will be effective during the second half of 2016. FINRA Press Release.
SEC Grants Accelerated Approval to ICC’s Proposal to Revise the ICC Clearing Rules to Include Information on Risk Policies
On June 13th, the SEC requested comments on ICE Clear Credit LLC’s (“ICC”) proposal to revise the ICC Clearing Rules to add explicit references to certain risk-related policies currently contained in the ICC Risk Management Framework and the ICC Risk Management Model Description document. The proposed rule change would add information related to the minimum time horizon for liquidation, anti-procyclicality conditions, and the maintenance of cover-2 default resources. The SEC also issued an order approving the proposal on an accelerated basis. Comments should be submitted within 21 days of publication in the Federal Register, which is expected the week of June 20, 2016. SEC Release No. 34-78055.
NYSE Proposes Amendments to Rules Defining the Trading Floor and Excluded Physical Areas
On June 13th, the SEC provided notice of a proposed rule change filed by the New York Stock Exchange LLC (“NYSE”) that would exclude an area of its location at 18 Broad Street that has fully enclosed telephone booths from the definition of Trading Floor. Comments should be submitted within 21 days of publication in the Federal Register, which is expected the week of June 20, 2016. SEC Release No. 34-78057.
Options Clearing Corporation
SEC Initiates Disapproval Proceedings Regarding OCC’s Proposed Risk Control Standards Policy
On June 13th, the SEC instituted proceedings to determine whether to approve or disapprove The Options Clearing Corporation’s (“OCC”) proposal to adopt a new Options Exchange Risk Control Standards Policy and revise its Schedule of Fees to impose on clearing members a fee for contracts executed on an options exchange that did not have adequate risk controls to meet the OCC’s proposed risk control standards. Comments should be submitted within 21 days of publication in the Federal Register, which is expected the week of June 20, 2016. Rebuttal comments are due within 35 days. SEC Release No. 34-78056.
FSOC Fights for Right to Label Financial Institution ‘Too Big to Fail’
On June 16th, DealBook reported that the Financial Stability Oversight Council (“FSOC”) appealed a district court decision to throw out the federal regulators’ designation of MetLife as “too big to fail.” The court had said that the FSOC had failed to consider the probability of MetLife’s going under and the impact that severe material distress at MetLife would have on the financial system. In its first substantive brief, the FSOC stated that “[t]he district court overturned the collective judgment of the heads of the nation’s financial regulatory agencies that material distress at MetLife could pose a threat to the country’s financial stability … [t]he court’s ruling leaves one of the largest, most complex and most interconnected financial companies in the country without the regulatory oversight that Congress found essential.”