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News December 21, 2015 Issue

The Year in Review: Challenges in Asset Management, Cybersecurity, Insider Trading

No two years are alike, and a review of 2015’s top developments that affected, or will affect, advisers and funds proves the point. 2015 was a year of challenges: proposed rules affecting asset managers, an intensified focus on cybersecurity that is only likely to intensify more, and an unexpected change to the definition of insider trading.

"The most significant regulatory development during 2015 was the flurry of new rules affecting asset management firms proposed by the SEC during the last six months," said Ropes & Gray counsel David Tittsworth, noting that the rules "are largely being driven by the SEC’s desire to push back on the Financial Stability Oversight Council’s potential play to designate asset management firms as systemically important (see below for more). Particularly for mutual funds, these new rules represent extremely far-reaching regulatory changes."

Stroock partner and former Division of Investment Management deputy director Robert Plaze made the point that "the SEC, by proposing aggressive new asset management rules like the rule on liquidity management, may have, in effect, successfully held off FSOC and the other prudential regulators by proposing to introduce its own form of prudential regulation."

Top developments

Following is a summary of 10 developments that shaped the asset management industry in 2015, followed by a month-by-month selection of the year’s top stories. While many of the developments listed were new in 2015, others are trends from past years that continued to have an impact this year. Readers may differ on the relative importance of the listings, but few will doubt that all had an impact.

  1. New asset management rules proposed. This month’s proposed rule covering the use of derivatives by mutual funds was just one of several proposed asset management rules offered by the SEC in 2015. Others covered liquidity risk management, portfolio reporting, Form ADV data, census reporting, structured data, and enhanced disclosure and website communications. Whether their proposal was part of the agency’s efforts to keep pace with a changing marketplace or part of an effort to hold off attempts by prudential regulators to intrude on its space (see below), the combined effect of the changes, once adopted – along with further expected proposals in 2016 – are likely to have a profound effect on how funds and their advisers conduct business (ACA Insight, 9/28/15, 5/21/15).
  2. Cybersecurity focus intensified. This one, which affects virtually every area of life today, is not going to go away. News of hackings, record thefts and more will only turn up the heat on both the regulators and on advisers. In 2015, the SEC staff listed cybersecurity as an examination priority, released results of an earlier cybersecurity examination sweep, issued guidance on cybersecurity practices, and took enforcement action against an adviser following a cyber breach (ACA Insight, 9/28/15, 9/21/15, 5/4/15, 2/9/15, 1/19/15).
  3. Insider trading definition changed. Perhaps the most unexpected turn of events that played out this year was a federal appellate court panel’s ruling (which actually occurred in December 2014) to toss out the conviction of two hedge fund executives – along with the until-then accepted definition of what constitutes insider trading. The U.S. Attorney’s Office for the Southern District of New York sought an appeal of the ruling, which it lost, and ultimately took the case to the U.S. Supreme Court, only to have the high court refuse to hear the case. Along the way there have been bills introduced in the U.S. Congress to resolve the problem in various ways, but none are given much chance of passage. How the changes will play out in terms of enforcement may take months, if not years, to decide, but have already resulted in some changes in case resolutions (ACA Insight, 10/12/15, 4/6/15).
  4. Private fund data used in examinations and enforcement. Ever since advisers to private funds began registering with the SEC in 2012, there has been concern that the agency would use the data it collects to bring enforcement actions against private equity funds and hedge funds. That concern only grew with the advent of Form PF. While SEC use of such data did not begin in 2015, this past year saw continued use, with more to come. In a May 2015 speech, then-acting director of the agency’s Office of Compliance Inspections and Examinations Marc Wyatt  addressed just what private equity issues OCIE planned to target (ACA Insight, 9/21/15, 7/20/15, 7/13/15, 6/15/15, 6/1/15).
  5. SEC enforcement actions against chief compliance officers raised concerns. A number of enforcement actions in which CCOs were named caught the attention of advisers and their defense counsel. This anxiety was only accentuated when then-commissioner Daniel Gallagher, in a June public statement, warned the agency against excessively targeting CCOs. This led to statements by SEC officials that the agency pursued CCOs only when certain lines were crossed. Division of Investment Management director Andrew Ceresney in November, in a speech before the National Society of Compliance Professionals, said that CCOs have the agency’s "full support." But not all were satisfied. Separately, the SEC issued a guidance alert in November warning of risks in hiring outsourced CCOs (ACA Insight, 11/16/15, 11/9/15, 8/3/15, 7/20/15, 6/29/15).
  6. Increased use of administrative hearings rather than federal courts led to changes. One of the longer-running battles this year pitted the defense bar (and its advisory firm clients) against the SEC over the agency’s admitted increased reliance on assigning cases to its own administrative law judges rather than trying them in federal court. The disagreement, which began in late 2014, centered on defense attorney arguments that assigning cases to SEC-employed ALJs gave the agency a home-court advantage, and that those charged did not have the same access as prosecutors did to discovery and other rules of due process. Ceresney vigorously defended the use of ALJs, saying, among other things, that ALJs provide in-house expertise and that decisions are made promptly. Commissioner Michael Piwowar called for guidelines to help govern the agency’s use of administrative hearings. The SEC in September proposed changes to administrative hearings that, if adopted, would meet some of the defense bar’s concerns (ACA Insight, 9/28/15, 11/2/15).
  7. SEC reliance on data analysis increased as it sought more money for examiners and other staff. The agency said in October that it filed a record 807 enforcement actions in the fiscal year that ended in September. It was not shy about crediting many of the cases, such as its ongoing Rule 105 crackdown, to its increasingly sophisticated use of data analytics. It plans to do even more with data management – and with additional examiners and other staff – with the $1.6 billion budgeted by Congress for the SEC in the recently agreed upon fiscal year 2016 spending bill, a $100 million increase over the $1.5 billion it received in the current fiscal year (ACA Insight, 11/2/15, 10/5/15, 7/20/15, 11/2/15).
  8. Turf war between the SEC and prudential regulators picked up steam. There is concern in the asset management community that prudential regulators – those bodies regulating banks and similar financial institutions – are seeking to make inroads into the asset management industry through organizations like FSOC. Under this view, the SEC’s proposed asset management rules and other actions are aimed at showing that such regulation is not necessary. Both Gallagher and Piwowar have said in speeches that prudential regulation of the asset management industry is not needed and would, in fact, be harmful (ACA Insight, 6/8/15, 4/20/15).
  9. Advertising involving hypothetical performance reports and backtesting was scrutinized in enforcement actions. The SEC has for years kept a close eye on advisers’ use of performance reporting in advertising, but this year it paid particular attention to two practices: the use of hypothetical performance and the use of backtesting. Several cases highlighted the issues, including the SEC’s $35 million settlement in December 2014 with investment management firm F-Squared Investments. Performance data from F-Squared also allegedly played a part in the agency’s $16.5 million settlement with Virtus Investment Advisers in November 2015 (ACA Insight, 12/14/15, 11/23/15, 10/19/15).
  10. Disqualification waivers became an issue in settlement negotiations. Gallagher, in a February speech, called on the Commission to vote on sanctions and conditional waivers together in one package. He addressed the problem advisers face when they negotiate settlements, but are left hanging as to whether they still may be subject to disqualification waivers. The argument is that there is little point in negotiating a settlement if, after it is over, an adviser finds it will still be disqualified – an action that may force it to go out of business. This sort of uncertainty should be addressed in the settlement process, Gallagher said. Piwowar, also in February, called for guidelines on the practice, and SEC chair Mary Jo White stated in March that disqualification waivers were not meant to be part of the enforcement process (ACA Insight, 3/16/15).

Month-by-month

Following is a list of selected 2015 SEC actions and other developments that had an effect on advisers and funds.

January

  • OCIE issues its 2015 examination priorities, which include reverse churning, alternative funds, and cybersecurity.
  • F-Squared Investments pays $35 million to settle performance advertising charges.

February

  • U.S. Attorney’s Office seeks an overturn of appellate court’s insider trading ruling.
  • Results from OCIE cybersecurity exam sweep reveal that advisers lag behind broker-dealers.
  • SEC FY 2016 budget proposal requests dollars to hire 225 more examiners.
  • Gallagher calls on the SEC to stop waiver practices that cause settlement uncertainty.
  • Piwowar calls for the SEC to issue guidelines on when administrative hearings may be held.

March

  • Division of Investment Management acting director David Grim announces that the SEC will propose Form ADV changes, transition plans and stress tests for advisers.
  • White states that disqualifications and waivers should not be issued in enforcement proceedings.
  • White endorses a uniform fiduciary standard for investment advisers and broker-dealers, and says that third-party examiners would be the best existing option to supplement the SEC’s own examination efforts.
  • The Investment Adviser Association and the Securities Industry and Financial Markets Association issue a joint statement saying that there is no systemic risk in the asset management industry, and that even if there was, the SEC should take the lead in addressing it.
  • Three bills – one introduced in the U.S. Senate and two in the House of Representatives – seek to define insider trading.

April

  • Second Circuit of the U.S. Court of Appeals chooses not to review key insider trading ruling.
  • Gallagher decries the possibility of asset managers being regulated like banks.
  • SEC’s Rule 105 dragnet fines an adviser $65,000 on allegedly illegal profits of $11,654.
  • SEC offers cybersecurity guidance with specific recommendations.
  • OCIE states in a risk alert that it will look at never-before-examined investment companies.

May

  • SEC issues guidance explaining how it chooses between administrative hearings and federal courts.
  • Wyatt shares what private equity areas examiners will focus on.

June

  • CCO and firm settle charges that the CCO failed to implement adviser’s compliance policies and conduct an annual review, as well as with being responsible for a material Form ADV misstatement.
  • SEC stresses compliance program failures in case against adviser.
  • Gallagher criticizes SEC pursuit of CCOs and calls for guidance. "For the vast majority of advisers, CCOs are all we have," he said.
  • SEC settlement with Kohlberg Kravis Roberts & Company is first-ever expense misallocation case involving broken-deal expenses against a private
    equity adviser.

July

  • SEC settlement with hedge fund adviser demonstrates the slippery slope of valuation shortcuts.
  • Justice Dept. asks Supreme Court to review insider trading ruling.

August

  • Anti-Money Laundering Rule proposed.
  • Gallagher urges SEC to stand strong against prudential regulators.
  • SEC report states that Form PF data is used by SEC for examinations and investigations.

September

  • OCIE reveals cybersecurity exam focus, issues sample information request list.
  • SEC proposes changes to administrative proceedings that address defense concerns.
  • SEC proposes liquidity management rules requiring classification of fund portfolio assets into six categories, establishment of a three-day liquid asset minimum for each fund, and other risk management measures.
  • First SEC distribution in guise settlement leaves adviser and affiliate with $40 million fine.

October

  • Supreme Court refuses to review insider trading ruling.
  • Bill introduced in House of Representatives would effectively reduce the number of administrative proceedings.
  • Gallagher and Piwowar dissent on Commission Opinion used to define performance backtesting.
  • SEC announces it set new record: 807 enforcement actions in FY 2015
  • First settlement announced in SEC cherry-picking initiative.
  • SEC’s Rule 105 dragnet snares six more advisers.

November

  • Ceresney tells CCOs that the SEC is not out to get them. CCOs, he said, have the agency’s "full support. We rely on you as essential partners in ensuring compliance."
  • SEC in risk alert warns that outsourced CCOs may result in compliance weaknesses.
  • Another adviser settles with the SEC over allegations involving advertising past performance, as well as past specific recommendations.

December

  • SEC proposes derivatives rule that would limit the amount of leverage a fund may obtain through derivatives and certain other transactions.