Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News October 23, 2006 Issue

Highlights From the NSCP Conference

Some of the more interesting discussions from last weekís NSCP conference:

E-mail word searches. At the Q&A session at the end of her keynote address, OCIE director Lori Richards was asked whether the SEC staff expects firms to conduct e-mail word searches. The conference attendee posing the question reported that his firm had run "dirty word" searches on e-mails, scanning for terms such as "cash" and "illegal." The results, however, overwhelmingly contained false hits. The attendee expressed concern about what might happen if his firm failed to detect a smoking gun e-mail. "We donít want to be whipsawed," he said.

Richards acknowledged that firms that conduct word searches find "all kinds of stuff that is certainly not nefarious." While emphasizing the importance of reviewing e-mails, she acknowledged that it would be virtually impossible for a firm to review every e-mail, particularly with respect to large organizations. Firms, she said, should take a "risk-based approach" to reviewing e-mail and be "thoughtful" about how the firm goes about sampling e-mails for review. "Iím sympathetic," she said. That would seem to be "the only thing you can do."

Later in the conference, Robert Plaze, associate director in the SECís Division of Investment Management, was asked when the SEC would issue written e-mail guidance. He declined to predict a date. "These are important issues for us," said Plaze, noting that he and other staff members have tried to provide oral guidance on e-mails at conferences. However, he added, the timing of the written guidance depends on "a lot of things going on at the Commission." He said that if it were up to him, the guidance would be issued "tomorrow."

Fee-based brokerage rule enforcement cases? This topic garnered quite a bit of discussion. The concern, as expressed by Plaze and OCIE associate director Gene Gohlke, is that brokerage firms may fail to correctly identify services that, per the terms of the new fee-based brokerage rule, fall under the Advisers Act. As a result, these firms may fail to properly register as an adviser (or establish an advisory affiliate) and/or fail to correctly identify specific client relationships as advisory in nature.

Why are the regulators so concerned? The numbers tell the story. According to Gohlke, the number of investment advisers that are dually-registered as broker-dealers remained constant before and after the adoption of the fee-based brokerage rule: In October 2004, there were 626 dual registrants. In October 2006, there were 627. "Weíre up one," he said.

Similarly, the number of advisers that reported having a broker-dealer affiliate remained steady, from 2,244 in October 2004 to 2,365 in October 2006. Based on those numbers, said Gohlke, it seems that all of the broker-dealers that were required to register as advisers as a result of the fee-based brokerage rule did so "way back." Or, he said, "they are completely ignoring it and saying, ĎLet the Commission come catch us.í"

What if the SEC brings an enforcement case against a broker-dealer, and in the course of the investigation, determines that the broker has been providing more-than-solely-incidental investment advice, but has not registered under the Advisers Act or treated that relationship as advisory in nature? "Suddenly," the SEC enforcement attorney "finds his settlement leverage quite changed," said Plaze. What started out as a small problem for the brokerage firm could turn out to be a larger problem, he said. "That hasnít happened yet," Plaze added, "but those of us on the staff are watching for it to happen."

Gohlke indicated that examiners will look at the process by which firms identify whether a particular client should be treated as a brokerage client, an advisory client, or both. When examining dual-registrants or advisers that have a broker-dealer affiliate, examiners "will certainly make inquiries" about brokerage customers that might be receiving advisory services, to see whether "all of the attributes of the Advisers Act" apply to that relationship and to the person providing the advice. Such an inquiry will be made both "at a point" as well as "on a continuing basis," he said, "because relationships change over time." The staff will look to determine whether the process for identifying a client as an advisory client or as a brokerage customer "makes sense" given the firmís business.

Mayer Brown partner Elizabeth Knoblock cautioned that some brokerage firms use third-party service providers that offer prepackaged tools to create a financial plan. The use of such tools, she said, puts a rep using those tools in the investment adviser representative category and should be viewed as a "red flag" that prompts internal questions about whether investment adviser status has been triggered. "I think thatís where the case Bob is looking for will come from," she said.

How will examiners review soft dollars? Gohlke said that examiners will be looking closely at disclosure of conflicts of interest presented by soft dollars. Often, he said, examiners discover that advisers do not adequately disclose the conflicts and how they impact the client. In addition, Gohlke said that examiners often find inadequate documentation of mixed use products to back up "how that hard/soft dollar split was arrived at." Examiners will not be pleased by a "seat of the pants" analysis with "really no support for that allocation."

Gohlke also noted that examiners will expect to find evidence that for each product that is softed, an adviser has made the requisite findings about eligibility (i.e., intellectual content), whether the product provides lawful and appropriate assistance to the adviser, and the other findings required under Section 28(e). "I think you can expect the examination staff" to ask for "things in writing" to demonstrate that the adviser has made those findings, said Gohlke. "If there is a soft dollar cost associated with a product," he said, then for that product, "you need to have documentation."

Pressed by his co-panelists, who expressed concern that it would be overly burdensome for an adviser to make such findings for, say, every research report, Gohlke clarified that examiners will not expect findings to be made on a product-by-product basis. Instead, the findings could be made on a product category basis or on a vendor-by-vendor basis, he said. The key, said Gohlke, is that the review be "reasonable." For example, in an area where the adviser "is pushing the envelope," by softing a product or service that may not clearly fall within 28(e), he said, the firm should be prepared to provide documentation of its findings to the staff.

Gohlke emphasized the need to conduct the analysis at the time the decision is made to soft the product or service. "You need to persuade your business units that they need to talk about this and have some documentation," he said. An "ad hoc," after-the-fact analysis by the law department, he said, will be viewed far less favorably than evidence that the business units went through a "considered process" at the time the soft dollar product was obtained.

"Getting-to-know-you visits." Gohlke noted that each year, over 1,000 new firms register as investment advisers. Often, he said, the only information that the SEC has about those firms is whatís provided on their Form ADVs. To get a better handle on these new registrants, OCIE is experimenting with a new approach, by which it visits a number of such new firms (either a sample, or as many as the staff can get to, Gohlke said). The staff will try to determine whether the firm is comprised of "a bunch of cowboys interested in ripping off their clients" or whether the firm seems "interested in developing a fiduciary relationship with their clients."

Hedge fund solicitors. Knoblock noted that during one of the CCOutreach regional seminars, the staff of the SECís North East Regional office announced that the SEC staff would no longer deem the cash solicitation rule to apply to persons who solicit investors for hedge funds. However, she pointed out, a person who solicits for an adviser itself is still subject to the cash solicitation rule. Consequently, she said, firms should think twice before deciding that their hedge fund solicitors do not need to comply with the cash solicitation rule. For example, say an adviser also offers private accounts. A solicitor meeting with a prospective hedge fund investor might be faced with the prospect of discussing that option to a potential client. To avoid any after-the-fact realization that what had started off as a discussion only about the hedge fund had, in fact, turned into a discussion about the adviserís other investment management services, Knoblock suggested that firms that offer both types of advisory services continue to apply the cash solicitation rule. "Do not open the door to the risk," said Knoblock. "Donít leave yourself unprotected." Plaze agreed. From a practical standpoint, he said, "tell them it applies."

Of note: While acknowledging that a solicitor that purely solicits investors for a hedge fund would not be subject to the cash solicitation rule, Gohlke noted that "there may be a broker-dealer issue there." At which point, Plaze chimed in: "There definitely is a broker-dealer issue there." Based on those comments, it seems that to the extent your shop hires outside parties to bring in hedge fund investors, the SEC staff would expect those folks to be registered as broker-dealers.

Extra scrutiny of newly-registered hedge fund advisers? Newly-registered hedge fund advisers are "no more likely to be examined than any other adviser," said Gohlke. If OCIE determines that a newly-registered adviser has a high risk level, he said, it will be put on a three-year cycle. Otherwise, it will join the "vast bulk" of advisers that do not fit that profile, which will be selected for random reviews. Hedge fund advisers, said Gohlke, "are in both of those two pools."

Other odds and ends . . .

  • Does the interpretive guidance provided by the Gardner Russo & Gardner no-action letter, which set 25 percent as the threshold for "proprietary-ness" of a pooled investment vehicle, apply to both registered and unregistered advisers? "Yes," said Plaze.
  • Look for a final manager-of-managers rule soon. Plaze reported that the staff plans to make a final recommendation to the Commission for adoption "by the end of the year." One of the recommendations coming out of a recent internal audit of the IM Divisionís exemptive application office was that the staff "set and monitor a deadline" for submitting the rulemaking to the Commission for consideration.
  • Plaze reported that the SEC staff is working away at raising the accredited investor threshold in Reg. D, under the theory that any threshold that "all the dentists in Arlington, Virginia" can meet is too low.