The following brief updates exemplify trends and areas of current focus of relevant regulatory authorities:
Wrap Fee Subadviser Sanctioned for Inadequate Disclosure of Brokerage Costs
On July 14, 2016, the SEC announced that it had settled an enforcement action against RiverFront Investment Group (“RiverFront”), a registered investment adviser. The SEC alleged that RiverFront made materially misleading statements to its advisory clients with respect to the brokerage costs incurred by investors in wrap fee programs. Clients in wrap fee programs pay an annual wrap fee that is intended to cover the costs of various services, such as custody, trade execution, portfolio management and back office services that are “wrapped” together by the program’s sponsor. Subadvisers to wrap fee programs typically use the brokerage firm designated by the sponsor of the wrap fee program to execute trades on behalf of clients in the program, and trades executed by the designated brokerage firm are covered by the wrap fee. However, in order to obtain best execution, a subadviser may decide to “trade away” from the designated broker-dealer by executing trades with other broker-dealers, resulting in additional charges to the wrap fee program clients.
The settlement order alleges that during the period from mid-2008 until March 2009, RiverFront executed almost all of the wrap fee program trades through broker-dealers designated by the sponsor. However, at the end of the first quarter of 2009, RiverFront significantly increased the number of trades that were “traded away” through other brokers and, by the beginning of 2010, RiverFront was trading away a majority of its trades for the wrap fee program. According to the SEC, “RiverFront did not profit by trading away, and it claims to have obtained improved execution prices by doing so.” Nonetheless, the SEC found fault with RiverFront’s alleged failure to adequately disclose its increased use of non-designated brokers and related additional costs to clients.
The order states that RiverFront’s Form ADV disclosed to its clients that it “might trade away in an effort to obtain best execution,” and that in such instances clients may pay transaction costs not covered by the annual wrap fee. However, the order further states that RiverFront’s Form ADV also disclosed to its clients that “if a client retains RiverFront through a wrap fee arrangement, RiverFront will generally execute transactions for the client’s account through the client’s Program Sponsor, in order to enjoy the greatest cost benefits of the wrap fee program.” Because the latter statement covered the period when RiverFront was trading away a majority of the trades for the wrap program accounts, the SEC found that statement to be materially misleading. As a result, the SEC determined that RiverFront willfully violated Section 204(a) of the Advisers Act and Rule 204-1(a) thereunder. In settlement of the action, without admitting or denying the SEC’s findings, RiverFront agreed to be censured, to pay a civil penalty of $300,000 and to post on its website on a quarterly basis the volume of transactions traded away from sponsors and the associated transaction costs paid by clients.
Financial Services Firm to Pay $1 Million Penalty for Cybersecurity Breaches
The SEC recently reached a $1 million settlement with a large financial services firm (the “Firm”) for its alleged failure to protect customer information. The SEC asserted that an employee of the Firm, who had access to two internal web portal applications, “misappropriated data regarding approximately 730,000 customer accounts, associated with approximately 330,000 different households,” between 2011 and 2014. According to the order, portions of the stolen data were posted to at least three Internet sites, together with an offer to sell a larger quantity of stolen data in exchange for “payment in speedcoins, a digital currency.” After discovering the data breach in a routine Internet sweep, the Firm interviewed the employee, who acknowledged that he had downloaded confidential customer data to his own data storage device. Although the employee denied posting any of the data on the Internet, “subsequent forensic analysis of the employee’s personal server revealed that a third party likely hacked into the personal server and copied the confidential customer data that the employee had downloaded from the Portals.”
The SEC determined that the Firm had failed to adopt written policies and procedures reasonably designed to protect customer data, in violation of Rule 30(a) of Regulation S-P. Specifically, the settlement order states that the Firm did not have reasonably designed and operating authorization modules to restrict employee access to only the confidential customer data to which an employee had a legitimate business need; to audit and/or test the effectiveness of such authorization modules; and to monitor and analyze employee access and use of client data. In settlement of the action, without admitting or denying the SEC’s findings, the Firm agreed to be censured and to pay a civil penalty of $1 million.
Federal Reserve Extends Volcker Rule Compliance Date
On July 6, 2016, the Federal Reserve Board approved an order that extends, until July 21, 2017, the conformance period for banking entities to divest ownership in certain legacy investment funds and terminate prohibited relationships with funds, as required under the Volcker Rule. The order notes that this is the final of the three one-year extensions that the Board is authorized to grant under the Volcker Rule, although the Board is also permitted to grant banking entities an additional transition period of up to five years to conform their investments in certain illiquid funds.
Revised Uniform Unclaimed Property Act Viewed as Favorable to Fund Shareholders
In July 2016, the Uniform Law Commission finalized the Revised Uniform Unclaimed Property Act (the “Revised Act”). The Revised Act, which the Investment Company Institute endorsed, contains provisions consistent with industry and shareholder advocacy groups’ efforts to blunt aggressive efforts by some states to claim mutual fund shares as abandoned property. For example, the Revised Act provides that shares of a fund will escheat to the state of the fund’s home office rather than to the state in which the fund is organized. This should permit shareholders to reclaim shares more effectively because they are more likely to know the state of a fund’s home office.
The Revised Act, like other uniform laws, is only a model for state legislation. States that have adopted prior versions of the Revised Act are likely to adopt the Revised Act in one form or another. Various states that have been more aggressive in their escheatment practices have not adopted the prior versions and, therefore, are not expected to adopt the Revised Act.