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March 25, 2015

Avoiding Securities Fraud Prosecution: Using the SEC’s 2015 examination priorities as a compliance roadmap when dealing with retail investors.

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The SEC annually provides registrants with a roadmap for avoiding securities fraud prosecution by identifying its examination priorities for that year. By proactively addressing these issues internally, registrants can stay one step ahead of the SEC and avoid potentially costly and damaging securities litigation.

Typically, one area on which the SEC tends to heavily focus its examination priorities is the protection of retail investors by ensuring financial professionals are fairly and transparently dispensing advice and selling securities. The SEC’s 2015 examination priorities are no exception. As the SEC acknowledges, registrants have begun to offer retail investors a broader and more complex range of investment products and services. A natural consequence of this is that some of these newly-offered products/services (e.g., private funds, illiquid investments, and structured products designed to generate higher yields in low-interest environments) will present risks that many retail investors have never previously seen.

As a result, among the SEC’s 2015 examination priorities are four initiatives aimed at protecting retail investors from the unique risks associated with these newly-offered products and services.

1. Protection of Retirement Assets

According to the SEC, investors are more dependent than ever before on their own personal investments for retirement. As a result, the financial services industry has begun offering a broader range of options to help individuals plan for, and live in their retirement years. To protect individual retirement investors, and to ensure they have the assets they need for retirement, the SEC has announced its intent to scrutinize registrants’ sales practices and recommendations related to retirement assets.

Sales Practices – The SEC will focus on assessing whether registrants are using improper or misleading practices when recommending the movement of retirement assets from employer-sponsored defined contribution plans to other investment vehicles. Registrants should update and review their disclosure policies to be sure they are clearly and thoroughly disclosing all risks associated with this type of recommendation. Registrants should also implement internal processes that encourage its agents to make these disclosures in writing whenever possible.

Suitability of Investment Recommendations – The SEC will also focus on examining whether registrants’ recommendations that retail investors invest retirement assets in complex or structured products and/or higher-yield securities are suitable. Registrants should be aware that the SEC will scrutinize any such recommendations, and they should be sure to conduct thorough due diligence of the investment vehicle, in particular any long-term or liquidity risks, before making such a recommendation. Registrants should also ensure their compliance departments confirm that any such recommendations are consistent with existing legal requirements.

2. Fairness of Fee Structures

The SEC has also announced its intent to focus on the increasing trend of financial professionals operating as dually-registered investment advisers/broker-dealers. In particular, in 2015 the SEC will be focusing on ensuring the fairness of the fees these dually-registered professional charge and the fee structures they employ.

Whereas broker-dealers typically charge investors a commission or mark-up on purchases and sales of securities, investment advisors—and, now, dually-registered investment advisors/broker-dealers—traditionally employ a much broader variety of fee structures. These fee structures may include charging clients: (i) hourly fees; (ii) fees based on the amount of assets under management; (iii) performance-based fees; or, (iv) “wrap” fees that encompass a bundle of financial services (e.g., investment advice, investment research, and brokerage services).

With the SEC focusing on the propriety of those and other non-commission fee structures, dually-registered professionals who offer multiple fee structures should be sure to recommend the fee structure that is in the best interest of the investor at the inception of the arrangement. Dually-registered professionals should also re-evaluate the selected fee structure on an ongoing basis to ensure that it remains the best and most efficient option for the investor as his/her investment priorities and portfolio develop over time. Given the SEC scrutiny on this issue, and the ease by which retail investors could become confused by the differences between the various fee structures, dually-registered professionals should carefully disclose all of the fee structure options to investors, in writing where possible, and should also discuss the benefits and detriments of each.

3. Transparency of “Alternative” Investments

One of the factors driving the trend of offering retail investors broader and more complex investment options is the increasing availability of so-called “alternative” investments, including investments that offer returns that are not correlated with the stock market. These types of investments have experienced rapid and significant growth compared to other categories, and this has resulted in stricter SEC attention in 2015.

Funds that offer “alternative” investments and “alternative” investment strategies should be aware that the SEC is placing them under a microscope. These funds should pay particularly close attention to:

Internal Practices and Policies – The SEC intends to focus on the leverage, liquidity, and valuation policies and practices funds employ with respect to “alternative” investments. Funds should proactively review those policies for completeness, and also take measures to ensure strict compliance with them.

Internal Controls – The SEC will also focus on the adequacy of funds’ internal controls. Funds should consult with their compliance departments and review all of their internal controls concerning staffing, funding, and empowerment of boards, compliance personnel, and back-offices. Funds should also, once again, take measure to ensure strict compliance with those internal controls.

Marketing – Lastly, the SEC will also focus on the manner by which funds market “alternative” investments to investors. Transparency with investors is the best policy, and funds are urged to err on the side of over-disclosure. Funds must be sure they are truthfully marketing “alternative” investments by clearly and thoroughly disclosing all potential risks, and should also document those disclosures in writing whenever possible.

4. Fixed Income Investment Companies

The SEC’s fourth 2015 examination priority that is aimed at protecting retail investors concerns fixed income investment companies. The SEC has observed that it is essentially a foregone conclusion that interest rates in the United States will rise at some point in the near future. In anticipation of this, the SEC plans to conduct a thorough review of mutual funds that have significant exposure to interest rate increases to ensure those funds’ retail investors are sufficiently protected from this eventuality.

Mutual fund and other investment companies that are particularly susceptible to interest rate increases should anticipate the SEC’s focus in 2015 and should implement appropriate compliance policies and procedures, as well as investment and trading controls that are sufficient to prevent misleading disclosures to investors. Additionally, these mutual fund and investment companies should also undertake thorough reviews of their investment and liquidity profiles to confirm that the profiles are consistent with all disclosures they are making to investors.

About the Author

Callan Stein

Callan Stein is an associate in Donoghue Barrett & Singal’s Boston office. He regularly represents small and large businesses in litigation and general corporate matters. You can follow him on Twitter at @CallanSteinEsq

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