by T. GormanPosted on Posted in SECActions

The Division of Examinations announced its 2022 Exam Priorities in a release dated March 30, 2022 (here). The 2022 priorities are, as usual, a blend of traditional considerations from past programs mixed with new and at times emerging issues. Each of the areas, as well as the program, are grounded in the four pillars of the program: promoting compliance; preventing fraud; identifying and monitoring risks; and informing policy. During the exam the Division will prioritize “several significant focus areas that pose unique emerging risks to investor and the markets . . .”

The program begins with what are called “Significant Focus Areas” which are then divided into several specialty areas. The five focus areas are common to the overall program. They are: 1) Private Funds; 2) ESG or Environmental, Social and Governance Investing; 3) Standards of Conduct; 4) Information Security and Operational Resiliency; and 5) Emerging Technologies and Crypto Assets.

Private Funds represent one of the largest RIA segments, currently at about 35% of advisories and $18 trillion. Over the past five years there has been a 70% increase in the assets managed by these funds. The funds range from fairly straight forward investment vehicles to those that are very complex.

Exams plans to focus on traditional questions such as issues under the Advisers Act. Those include the fiduciary duty of advisers as well as the risks and the focus of the funds. Exam will assess the risks faced by the funds as well as the compliance programs, fees and expenses, custody arrangements, valuation methods and disclosures employed.

The program will also consider five specific items: 1) the calculation and allocation of fees and expenses; 2) the potential preferential treatment by some RIAs to funds that have experienced issues with gates, liquidity, suspensions, and withdrawals; 3) compliance with the Advisers Act, including the custody rule; 4) compliance with regulatory requirements and disclosure obligations; and 5) conflicts around liquidity and stapled secondary transactions.

Finally, the Division will examine the portfolio strategies, risk management and investment recommendations and allocations. This will include fund investments in special purpose entities or SPACs, particularly when the adviser is also a SPAC sponsor. Practices, controls and investor reporting will also be evaluated, particularly where there is outsized counter-party exposure.

ESG investing represents a growing trend, spurred by investor demand. There is a risk with these programs of false and misleading statements. This stems in part from the lack of standardization in the area as well as the size and growing complexity of the area. There are also a variety of approaches being employed which can increase risk.

The Division will focus on three key points here. First, the accuracy of the disclosure regarding ESG investing. Second, the voting of client securities in accord with proxy voting policies and procedures regardless of whether it aligns with the ESG related disclosures. Third, if the fund is overstating or misrepresenting the ESG factors considered or incorporated into portfolio selection.

Standards of Conduct focuses on Regulation BI, Fiduciary Duty and Form CRS. Exam will focus on how these standards are being satisfied. For broker-dealers and RIAs there will be a focus on compliance programs, testing, and training that is “designed to support retail investors and working families receiving recommendations and advise in their best interest.”

Broker-dealer exams will focus on sales practices related to SPACs, structured products, leveraged and inverse exchange traded products, annuities, municipal securities and other fixed income investments and microcap securities. Exams will also consider and evaluate costs, and available alternatives as well as recommendations of products. In addition, the compensation structure as well as any related conflicts will be evaluated.

RIA exams will focus on whether advisers act consistently with their fiduciary duties to clients as well as conflicts and disclosures. Four areas are key: 1) revenue sharing arrangements; 2) recommending or holding more expensive classes of shares; 3) the recommendation of shares that carry fees and 4) recommendations regarding proprietary products. Compliance policies and procedures and their design and implementation will also be evaluated.

Dually registered RIAs and broker-dealers are an “area of interest for the Division.” There will be an evaluation of potential conflicts of interest, including those from account recommendations and allocations of investments across different accounts. Exams will focus on: 1) the sale or recommendations of high fee products; 2) the sale or recommendation of proprietary products of the firm or affiliates; 3) incentives for financial professionals to place their own firm’s interest before that of customers and clients; and 4) if the compensation structures inappropriately influence investment recommendations. Written policies and procedures will also be analyzed.

Information security and operation resiliency is critical to ensure business continuity. Thus, the Division will review broker-dealer and RIA practices designed to prevent interruptions to mission-critical services and protect investor information. Accordingly, Exams will consider: 1) measures taken to safeguard customer accounts and prevent intrusions; 2) evaluate steps taken to oversee vendors and service providers; 3) examine steps taken to address malicious email activities; 4) responses to incidents; 5) steps taken to identify and detect red flags; and 6) evaluate steps taken to manage operational risk as a result of a dispersed workforce. Finally, the exams will consider business continuity and steps taken in this area.

Emerging tech and crypto assets will also be examined. Specifically, the Division will review the use of “robo-advisers” and the growing trends in this area. The unique risks in these areas will also be evaluated.

Similarly, Exams will evaluate the controls of RIAs and broker-dealers who are involved with crypto assets. Custody arrangement for the asses will be reviewed. In addition, consideration will be given to if those involved in these areas and if they have met their standards of conduct with respect to recommending and giving advice, a point which wraps back to each of the other areas discussed.

Comment

The Division of Examinations covers the waterfront of regulated entities. From investment advisers to broker-dealers and investment companies, the Division’s Examination Priorities 2022 discusses key questions for each. Building on themes developed over the years, the Division plans to examine a range of issues such as: compliance with the custody rule by private funds; climate and ESG questions presented by certain market professionals and products; compliance with the varying standards of conduct applicable to market professionals; cybersecurity an operational resiliency in an evolving environment in which cyber attacks are ever present; and the new questions presented by so-called “robo” advisers and crypto assets which remain a fascination of many but are often little understood.

The Exam Priorities are a valuable guide not just for preparation to meet with the Division. They also offer insight into key areas and issues faced by market professionals. Yet the best preparation for a meeting with Exams begins not with the Division’s discussion of its priorities but with the instillation, implementation and continued improvement of an effective compliance system driven from the top down. It is that system, key to the proper operation of the professional organization, that serve investors and the public as guided by the tone from the top. It is impact of that tone from the top as implemented by the organization that Exams evaluates.

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by T. GormanPosted on Posted in SECActions

Greenwashing is the term de jure. The Division of Exams announced its priorities for 2022 on March 30, 2022 (here). One portion of the exams will focus on climate and ESG. In their publication the Division identifies potential issues to consider. One centers on claims regarding climate and ESG that may be exaggerated. Another involves the discussion of ESG at a time when the standards are fluid and may not be well defined. A full discussion of the Division’s publication for 2022 will be published on Wednesday.

Be careful, be safe this week

SEC

Proposed rules: The Commission proposed rules designed to enhance disclosures related to SPACs, on March 30, 2022 (here). The proposals include provisions that would require additional disclosure about the sponsors, conflicts of interest and sources of dilution. In addition, additional disclosures would be required regarding business combinations between SPACs and private operating companies.

Supreme Court

Gag rule: Romeril v. Securities & Exchange Commission, No. 21-1284 (S.Ct. Filed: March 21, 2022). Barry Romeril settled an enforcement action with the Commission in 2003. The settlement included an injunction and the payment of disgorgement and penalties. The settlement also included the standard agency prohibition included in neither admit nor deny settlements precluding Defendant from taking any action or making any public statement denying any allegation in the compliant. In May 2019 Plaintiff filed suit alleging what he called a “gag rule” violated his rights under the First Amendment and the due process clause of the constitution. The district court and the Second Circuit rejected the claims. See SEC v. Allaire et al., Case. No. 19-4197-cv (2nd Cir. Decided 2021). Note, the original post was written by guest author Erica Andrews, Attorney, Dorsey & Whitney LLP, Washington.

SEC Enforcement – Litigated actions

Conflicts: SEC v. Duncan, Civil Action No. 3:1o-cv-11735 (D. Mass.) is a previously filed action which named as defendant Richard G. Duncan. Defendant was alleged to have defrauded two clients by soliciting them to invest in a Turkish investment opportunity. Prior to marketing the opportunity, two banks advised Mr. Duncan that the investment opportunity was most likely a scam. Rather than investigating the opportunity, Defendant just solicited two advisory clients who invested over $530,000. In March the matter was tried to the Court for three days. On September 15, 2021, the Court found that that Defendant had violated his duties under Sections 206(1) and 206(2) of the Advisers Act. The violations were based on omitting and misrepresenting material facts regarding the conflict between the interests of the adviser and the client. On March 30, 2022. The Court entered a final judgment that permanently enjoins Mr. Duncan from violating in the future the Sections alleged in the charges. In addition, the Court directed that Defendant pay disgorgement of $104,080, prejudgment interest of $14,716 and a penalty of $414,366. See Lit. Rel. No. 25354 (March 31, 20220).

Manipulation: SEC v. Lemelson, Civil Action No. 18-civ-11926 (D. Mass.) is a previously filed action which named as defendants Gregory Lemelson and his firm. The complaint alleged violations of Exchange Act Section 10(b) and Advisers Act Section 206(4). The charges were based on allegations that Defendants engaged in a scheme to drive down the share value of San Diego based Ligend Pharmaceuticals Inc. The case was tried to a jury which concluded that in fact Defendants made three false statements in a short period of time. The jury rejected claims that the Defendants engaged in an overall scheme to defraud, however. During the remedies phase the Court analyzed the evidence and concluded that while an injunction should be entered because Mr. Lemelson was in a position to engage in future violations and remained unrepentant, a permanent injunction was not warranted because his conduct “was not as severe as in many of the cases where courts ordered permanent injunctions. A temporary injunction is more appropriate in this case. This Court sets the inunction for a period of five years,” according to a Memorandum prepared by the Court. A penalty of $160,000 was also imposed. See Lit. Rel. No. 25353 (March 31, 2022).

SEC Enforcement – Filed and settled actions

Last week the Commission filed 2 civil injunctive actions and no administrative actions, exclusive of 12j, tag-a-long and other similar proceeding (one action is not discussed since the author has a conflict).

Offering fraud: SEC v. Dow Rockwell LLC, Civil Action No. 3:22-cv-02069 (N.D. CA. Filed March 31, 2022) is action which names as defendants the firm and Richard Dow Rockwell. The firm, controlled by Defendant Rockwell, is a California registered investment adviser. Over a three-year period, beginning in September 2017, Defendant acted as an unregistered broker on behalf of Professional Financial Investors, Inc., a real estate investment and management company. The adviser raised about $8 million from these offerings through the sale of unregistered securities. Investors who purchase the securities were told that those handing the transactions did not receive transaction-based compensation which was false. Those investors also were not told that Mr. Rockwell had a prior criminal conviction or that in fact Professional Investors was a Ponzi scheme operated by its now deceased founder who had misappropriated over $35 million from funds raised by the solicitation of over 1,300 investors. The complaint alleges violations of Advisers Act Sections 206(1), 206(2) and 207, Securities Act Sections 5(a) and 5(c) and Exchange Act Section 15(a). The case is pending. See Lit. Rel. No. 25354 (April 1, 2022).

Offering fraud: SEC v. Chatfield PCS Ltd., Civil Action No. 1:21-cv-00641 (D. Colo) is a previously filed action which names as defendants Tre Jay Scarlett, Chartfield PCS Ltd. and Go ECO. It centers on Go ECO, an environmentally conscious firm that manufactured and bottled a one shot protein beverage that supposedly would become the number one such drink. An investment would return a 20% to 25% return. Two offerings of shares have been conducted by Defendants since March 2016. The funds were to be used for the company. The complaint claimed that in fact the company never operated and much of the investor money was misappropriated. To resolve the matter Defendants Jay Scarlett, Chartfield PCS Ltd. and Go ECO consented to the entry of permanent injunctions based Securities Act Section 17(a) and Exchange Act Section 10(b). In addition, the order imposes conduct-based injunctions and orders the payment, on a joint and several basis, of $3,217,568 in disgorgement, along with prejudgment interest of $407,695. Defendant Scarlett was individually directed to pay a penalty of $1.5 million. See Lit. Rel. No. 25361 (March 31, 2022).

Insider trading: SEC v. Sure, Civil Action No. 3:22-cv-01967 (N.D. Cal. Filed March 28, 2022). The action centers on trading in advance of the first quarter 2020 earnings release, published on May 6, 2020 of Twilio, Inc. The firm is a San Francisco based cloud computing communications company. Three of the defendants were employed at Twilio: Hari Sure, Lokesh Lagudu and Chotu Pulagam. Each was employed as a software engineer. Others named as defendants in the action are: Dileep Kamujula, Sai Nekkalapudi, Abhishek Dharmapurikar and Chetan Pulagam. Between late March and early May the employee Defendants each obtained inside information regarding the firm’s revenue for the period by accessing Twilio data bases. Each either tipped friends or traded for their personal account as follows: 1) Defendant Sure tipped Kamujula, a close friend; 2) Defendant Laguda tipped Nekkalapudi, his girlfriend: 3) Defendant Laguda also tipped Dhrmapurika, a former roommate; 4) Defendant Chotu Pulagam tipped Chetan Pulagam, his brother; 5) Defendant Kekkalapudi traded for his account; and 7) Defendant Dharmapurikar traded for his own account. Essentially each tippe traded while the tipper did not; each Defendant who did not tip anyone traded profitably. The trading ring netted over $1 million in illicit profits from trading Twilio securities prior to the announcement. The complaint alleges violations of Exchange Act Section 10(b). The U.S. Attorney’s Office for the Norther District of California announced criminal charges against Dileep Kamujula. See Lit. Rel. No. 25350 (March 29, 2022).

ESMA

Report: The European Securities and Markets Authority published its final report on the EU carbon market on March 28, 2022 (here). The Report concluded that there were no major deficiencies in the functioning of the EU market. It also contains a number of policy recommendations to improve market transparency and monitoring.

Hong Kong

Announcement: The Hong Kong Securities and Futures Commission announced on March 31, 2022, that The Green and Sustainable Finance Cross-Agency Steering Group welcomes the publication of the International Sustainability Standards Board proposals for public consultation. The ISSB is seeking feedback through a public consultation process. The goal is to complete the process by the end of the year (here).

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