The following brief updates exemplify trends and areas of current focus of relevant regulatory authorities:
SEC OCIE Issues Risk Alert on Outsourced CCOs
On November 9, 2015, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert (the “Alert”) to raise awareness of potential compliance issues arising from the growing trend in the investment management industry of outsourcing compliance activities, including outsourcing the role of adviser or fund chief compliance officer (“CCO”). The Alert states that its purpose is to share OCIE staff’s observations from nearly 20 examinations of advisers and funds (“registrants”) that outsource their CCOs to unaffiliated third parties (“outsourced CCOs”).
OCIE staff’s general observations regarding outsourced CCOs included:
- Communications. Outsourced CCOs who have frequent and personal interaction with adviser and fund employees (instead of impersonal interaction, such as email and pre-defined checklists) appear to have a better understanding of the registrants’ businesses, operations, and risks. These registrants tend to have fewer inconsistencies between their compliance policies and procedures and their actual business practices, and their outsourced CCOs were typically able to effect compliance changes that are deemed necessary.
- Resources. More significant compliance issues were identified at registrants with an outsourced CCO who also served as outsourced CCO for multiple registrants and who did not appear to have adequate resources, particularly in view of the varied nature of registrants served by the outsourced CCO.
- Empowerment. Outsourced CCOs who were able to obtain registrants’ records independently – without relying on registrants to select the records – produced annual reviews that better reflected the registrants’ actual practices.
OCIE staff’s specific observations regarding the strength and effectiveness of the registrants’ compliance programs included:
- Outsourced CCOs who used standardized or generic checklists to gather information regarding registrants may not fully capture the business models, practices and compliance risks applicable to the registrants. Similarly, compliance manuals that had been created based upon templates provided by outsourced CCOs may not have been tailored to registrants’ specific businesses and practices. Therefore, the resulting compliance manuals contained policies and procedures that were inappropriate or inapplicable to the registrants’ businesses.
- Registrants that relied on outsourced CCOs were less likely to have written policies, procedures or disclosures to address all of the conflicts of interest identified by the OCIE (e.g., compensation practices, portfolio valuation, brokerage and execution, and personal securities transactions by access persons).
- Outsourced CCOs were typically responsible for conducting and documenting registrants’ annual compliance program reviews, including testing for compliance with existing policies and procedures. However, there was a general lack of documentation evidencing such testing.
- Some outsourced CCOs visited registrants’ offices infrequently and conducted reviews of compliance documents off-site. Consequently, the outsourced CCOs’ visibility within registrants’ organizations appeared to be limited, resulting in outsourced CCOs with limited authority to improve compliance policies and procedures.
The Alert notes that registrants, particularly those that use outsourced CCOs, may want to consider the contents of the Alert to assess whether their particular business and compliance risks were identified so that related policies and procedures were appropriately tailored to these risks. The Alert also recommends that registrants consider whether their CCO is sufficiently empowered within the registrant organization to fulfill the responsibilities of a CCO.
Adviser Enters into Settlement with SEC for Advertising False Performance Claims
On November 16, 2015, Virtus Investment Advisers, Inc. (“Virtus”) agreed to settle allegations resulting from an SEC investigation into alleged misstatements by Virtus to certain of its mutual fund clients and to those funds’ shareholders concerning the performance record of the funds’ subadviser, F-Squared Investments, Inc. (“F-Squared”).
F-Squared used a proprietary investment strategy called AlphaSector. Between September 2009 and May 2015, Virtus advised six mutual funds that relied on AlphaSector and employed F-Squared as subadviser to the funds. The SEC alleged that from May 2009 to September 2013, in certain client presentations, marketing materials, filings with the SEC, and other communications, Virtus had stated falsely that (i) the AlphaSector strategy had a history that dated back to April 2001 and had been in use since then; and (ii) the strategy had significantly outperformed the S&P 500 Index from 2001 to September 2008.
The SEC found that F-Squared had not employed the strategy from 2001 through September 2008 and had overstated the hypothetical performance of AlphaSector for the period. Thus, Virtus was alleged to have advertised the AlphaSector strategy by using hypothetical and back-tested historical performance that was substantially inflated. The SEC also alleged that Virtus had failed to adopt and employ adequate policies and procedures regarding the accuracy of performance information from third parties in Virtus’ marketing materials and other disclosures.
As part of the SEC settlement, Virtus agreed to disgorge $13.4 million and pay prejudgment interest of $1.1 million.
SEC Sanctions Adviser for False Claims of GIPS Compliance in its Advertisements
On October 30, 2015, the SEC upheld an administrative law judge’s decision regarding an adviser, ZPR Investment Management, Inc. (“ZPR”), and its former president and owner (“Zavanelli”). The SEC found that ZPR had violated various anti-fraud provisions of the Advisers Act, as well as the “advertising rule,” Rule 206(4)-1, under the Advisers Act, by misrepresenting ZPR composite’s compliance with the Global Investment Performance Standards (“GIPS”) in magazine advertisements and investment report newsletters. Zavanelli was found to have caused each of ZPR’s violations based on these misrepresentations. The SEC imposed a $250,000 civil money penalty on ZPR and a $570,000 civil money penalty on Zavanelli. The SEC also permanently barred Zavanelli from association with any adviser, broker or dealer.
SEC Focused on Variable Annuity Fee Table Disclosure and Buyback Offer Disclosure
On November 2, 2015, at an industry conference on insurance company investment products, David Grim, Director of the SEC’s Division of Investment Management, spoke on the regulatory and compliance issues affecting investment products issued by insurance companies. In particular, Director Grim identified two disclosure areas that have garnered increased focus by the SEC. First, he stated that the variable annuity fee table has become quite complicated for many products, particularly those that include various guaranteed benefit riders, and noted that the staff is looking for a clear and comprehensive fee table when reviewing variable annuity filings. Separately, Director Grim discussed a trend that the staff has observed among several variable product issuers. He stated that the staff “continues to see buyout offers [to contract holders] relating to variable insurance contracts with generous guaranteed income benefits and death benefits that, over time, have proven costly for insurance companies and their hedging programs in light of the ongoing low interest rate environment.” He noted that certain offers to contract owners limit an insurer’s exposure under existing guaranteed benefits, and may not be beneficial for all, or even most, contract owners. Accordingly, Director Grim indicated that the staff will continue to review carefully the disclosure relating to such offers, and he encouraged the industry to monitor sales practices associated with these offers carefully.
DOL Issues Guidance on Economically Targeted Investments
In October, the Department of Labor (“DOL”) published Interpretive Bulletin (“IB”) 2015-01 providing guidance to pension plan fiduciaries on ERISA standards as applied to “economically targeted investments” (“ETIs”) – defined as “investments that are selected for the economic benefits they create in addition to the investment return.” This new guidance withdraws IB 08-01 and reinstates the language of IB 94-01 stating that such considerations may be used as “tie-breakers” to decide between economically equivalent investments. IB 08-01 was withdrawn, in part, because the DOL believed the prior guidance “unduly discouraged” fiduciaries from investing in ETIs even where economically equivalent to competing investments or from pursuing strategies that considered environmental, social and governance (“ESG”) factors. This latest release confirms the DOL’s view that under Section 403 and 404 of ERISA, fiduciaries may invest in ETIs based on their collateral benefits so long as the investment is appropriate for the plan and economically equivalent to competing investments. In the preamble to IB 2015-01, the DOL states that ESG factors may have a direct relationship to the economic value of an investment. In these instances, the factors act as more than just “tie-breakers” and are proper components of economic analysis. The DOL noted, however, that consideration of these factors does not allow a plan fiduciary to sacrifice economic interests in pursuing collateral benefits.
Regulators Provide Guidance on ESC Securities Held by a State
In IM Guidance Update No. 2015-04 (the “Guidance”), the Division of Investment Management provided guidance regarding states holding securities issued by Employees’ Securities Companies (“ESCs”). Under Section 2(a)(13) of the 1940 Act, ESCs are employer-sponsored investment companies, the beneficial owners of which generally include only current and former employees and employer retainers (“Eligible Holders”). The Guidance notes that the SEC has exercised its exemptive authority by exempting ESCs from various restrictions that would otherwise apply under the 1940 Act.
On occasion, the Guidance states, a state may become the holder of an ESC’s securities through operation of the state’s escheatment laws. States are not Eligible Holders. This raises the question of what effect a transfer of ESC securities to a state by operation of the state’s escheatment law has on the ESC’s ability to rely on an existing exemptive order.
The Guidance states the Division of Investment Management would not object if an ESC continued to rely on its exemptive order under the 1940 Act if securities issued to Eligible Holders consistent with the ESC’s relevant exemptive order are remitted to, and held by, a state, by operation of the state’s escheatment law. However, this position is limited to the transfer of ESC securities to a state by operation of the state’s escheatment law, and does not extend to any other transfers of ESC securities.
SEC Announces Results of 2015 Enforcement Program
On October 22, 2015, the SEC announced its enforcement results for its fiscal year ended September 30, 2015. According to the announcement, the SEC filed 807 enforcement actions in fiscal 2015 covering a wide range of misconduct (compared to 755 such actions in the prior year), and obtained orders totaling approximately $4.2 billion in disgorgement and penalties (compared to $4.16 billion in the prior year).