The SEC has made investment advisers and companies an enforcement priority, and it wants whistleblowers to help expose violations of the law. The law entitles eligible whistleblowers to receive a reward if their original information leads to the recovery of at least $1 million.
Under the Dodd-Frank Act, whistleblowers may receive a reward for reporting original information to the SEC about violations of federal securities laws. Since the law went into effect, the SEC has paid more than $149 million to 41 whistleblowers. One whistleblower received more than $30 million for providing key information that led to a successful enforcement action.
SEC Targeting Investment Fraud
In FY 2016, the SEC set a record for the number of actions brought against investment advisers and companies. The SEC brought 160 such actions – more than 18% of the total number of SEC actions in FY2016.
This scrutiny is only going to increase. The SEC plans to increase staffing in its investment adviser/investment company examination program by 20%, according OCIE Director Marc Wyatt in a recent speech.
Whistleblowers Are Critical to Enforcement of Anti-Fraud Laws
Despite the increased resources, whistleblowers remain a key source of information for the SEC. Many registered investment advisers are regulated solely by the SEC, and unlike registered broker-dealers, investment advisers have no self-regulatory organization. Further, more than 2,000 new investment advisers have registered with the SEC within the past two years.
Whistleblowers play a vital role in helping the SEC enforce laws when its resources are stretched thin. As SEC Chair Mary Jo White stated, “[Whistleblowers] provide an invaluable public service, and they should be supported…We have seen enough to know that whistleblowers increase our efficiency and conserve our scarce resources.”
Examples of Investment Company Act Violations
The SEC defines investment companies as any corporation, business trust, partnership, or limited liability company that issues securities and is primarily engaged in the business of investing in securities. The SEC may bring an enforcement action against an investment adviser for a host of violations, including:
- Failing to disclose fees, charges, and conflicts of interest;
- Failing to maintain adequate written policies and procedures;
- False or misleading advertising; and
- Failing to safeguard customer data.
In the past year, notable areas of fraud that have produced substantial settlements and penalties include:
Failing to Disclose Fees, Charges, or Conflicts of Interest
Section 206 of the Investment Adviser Act of 1940 (IAA) prohibits fraudulent and deceptive conduct, and Section 207 proscribes material misstatements in investment adviser registration applications or reports. The SEC relies on these statutory authorities to bring enforcement actions when investment advisers fail to disclose conflicts of interest, as well as client fees or charges.
For example, in December 2015, two JP Morgan wealth management subsidiaries agreed to pay $267 million to settle charges that they failed to disclose conflicts of interest to clients. According to the SEC order, the investment advisory business and the bank invested clients in the firm’s own proprietary investment products without properly disclosing this preference. In a parallel action, JP Morgan Chase Bank agreed to pay an additional $40 million penalty to the U.S. Commodity Futures Trading Commission (CFTC). (Note: the CFTC also has a whistleblower program that offers rewards for original information that leads to successful enforcement actions.)
In the SEC’s press release, the Director of the Enforcement Division, Andrew J. Ceresney, stressed the importance of adequate disclosure concerning conflicts of interest. He stated: “Firms have an obligation to communicate all conflicts so a client can fairly judge the investment advice they are receiving. These J.P. Morgan subsidiaries failed to disclose that they preferred to invest client money in firm-managed mutual funds and hedge funds, and clients were denied all the facts to determine why investment decisions were being made by their investment advisers.”
Other notable recent actions for failures to disclose conflicts, fees, or charges include:
- In October 2015, three private equity fund advisers within the Blackstone Group paid almost $39 million to resolve allegations they violated Section 206 for failing to disclose accelerated monitoring fees and a conflict of interest. Nearly $29 million was returned to investors;
- In November 2015, Fenway Partners LLP and four of its employees paid more than $10 million to settle charges that it violated Section 206 by failing to disclose a conflict of interest regarding the payment of fund and portfolio company assets to former employees and an affiliated entity.
- In September 2016, WL Ross & Co. LLC paid $2.3 million to resolve charges that it failed to disclose material information regarding fee allocation practices, in violation of Sections 206(2) and 206(4).
Failing to Maintain Adequate Written Policies and Procedures
Rule 206(4)-7 requires investment advisers to maintain written and policies and procedures reasonably designed to prevent violations of the IAA. An investment adviser’s failure to do so violates Section 206(4). The SEC routinely enforces this provision in conjunction with other charges. Some of the cases above included charges that the investment advisers also violated Rule 206(4)-7. Other examples include:
- On August 23, 2016, four private equity fund advisers affiliated with Apollo Global Management agreed to a $52.7 million settlement to resolve a variety of charges, including that the advisers violated Section 206(4) and Rule 206(4)-7 by failing to maintain adequate policies and procedures.
- On September 14, 2016, First Reserve Management LP resolved allegations, including that it had violated Rule 206(4)-7, for $3.5 million.
Parking and Steering
Parking and steering schemes may constitute fraudulent practices in violation of Section 206. Parking is a practice of prearranged trading that benefits one account over another. Unlawful steering occurs when an investment adviser directs a client to investments that will generate higher fees for the adviser, without disclosing the conflict of interest to clients. Recent parking and steering cases include:
- In December 2015, Morgan Stanley Investment Management agreed to pay $8.8 million to resolve the SEC’s claim that a portfolio manager colluded with a brokerage firm trader to trade at prearranged prices to the benefit of some client accounts, but the detriment of others.
- In March 2016, three AIG affiliates paid more than $9.5 million to settle charges that they steered clients to investments that put unnecessary charges on the investor but generated an additional $2 million in fees without disclosing the conflict of interest.
False or Misleading Advertising
Section 206 of the IAA, and Rule 206(4)-1 in particular, also regulates investment advisers’ advertisements. The rule limits testimonials and recommendations and prohibits false and misleading advertising. For example:
- In August 2016, thirteen investment advisory firms paid varying penalties for a total of $2.2 million to settle allegations that they spread false claims made by investment management firms about its flagship product.
Failing to Safeguard Customer Data
Morgan Stanley Smith Barney LLC agreed to pay a $1 million penalty to settle charges for its failure to protect customer data. According to the SEC order, the firm did not adopt written policies and procedures reasonably designed to protect customer data. Some of the data was hacked and even offered for sale online.
According to PwC’s 2016 crime survey, economic crime has outpaced company preparedness and, as a result, U.S. organizations have experienced an increase in cybercrime compared to prior years. This will continue to be priority enforcement area for the SEC. Companies should ensure compliance with federal securities laws, which require investment companies to adopt written policies and procedures reasonably designed to protect customer records and information.
Negligent Conduct Violates the IAA and Scienter is Not Required
Unlike many other laws dealing with fraudulent conduct, the IAA may be violated when the investment adviser is merely negligent, as opposed to specifically intending to defraud a client. For example, because Section 206(2) prohibits conduct that operates as a fraud, an investment adviser may engage in prohibited conduct merely through negligence.
SEC Dodd-Frank Whistleblower Reward Program
Under the SEC Whistleblower Program, whistleblowers may be eligible for monetary awards when they voluntarily provide the SEC with original information about violations of federal securities laws that leads the SEC to bring a successful enforcement action resulting in monetary sanctions exceeding $1 million.
The SEC Whistleblower Program also protects the confidentiality of whistleblowers and does not disclose information that might directly or indirectly reveal a whistleblower’s identity. Furthermore, the Dodd-Frank Act protects whistleblowers from retaliation by their employers for reporting violations of securities laws.
Whistleblowers may file a tip with the SEC anonymously if they are represented by an attorney.