A Compilation of Enforcement and Non-Enforcement Actions - June 2012

Non-Enforcement

More Time Allowed to Comply With Pay-to-Play Third-Party Solicitation Ban
The SEC recently announced that the deadline to comply with the pay-to-play rule (Rule) adopted in June 2010 under the Investment Advisers Act of 1940 has been extended. The Rule was adopted by the SEC for the purpose of curbing the pay-to-play practices of registered investment advisers seeking business from public pension and other governmental plans. The new compliance date for the effectiveness of the Rule is now nine months after the compliance date of a final rule (yet to be adopted) by the SEC requiring “municipal advisers” to register with the SEC. It is expected that once the final rule on municipal adviser registration is adopted, the SEC will announce a new date for compliance with the Rule.

The Rule includes provisions that bar investment advisers from paying third parties to solicit for government clients, unless the third party is an SEC-registered investment adviser or broker-dealer that is subject to similar pay-to-play restrictions. The SEC believes that FINRA will soon propose a broker-dealer pay-to-play rule. The main reason for the extension of time to comply with the Rule is the fact that the SEC to date has not finalized a rule to define “municipal adviser” and who must register as such.

It is expected that the extension of the compliance date for the Rule will allow registered investment advisers much-needed additional time to design and implement compliance policies and procedures designed to comply with the Rule.

Some Interesting SEC Registration Numbers Due to the Dodd-Frank Act
Now that the March 30, 2012 deadline has come and gone (the date was the compliance date for several provisions included within the Dodd-Frank Act), the SEC’s Division of Investment Management recently reported on the impact of the Dodd-Frank Act provisions with respect to investment advisers registered with the SEC as of that date. As of March 30, 2012: (i) advisers to certain private funds were required to register for the first time; (ii) exempt reporting advisers were required to submit reports to the SEC on the funds they managed; and (iii) so-called “mid-sized” investment advisers (i.e., advisers with assets under management of between $25 million and $100 million) were required to switch registration from the SEC to one or more states (although that date was further extended to June 28, 2012).

The SEC reported post-March 30 registration numbers are as follows:

• Out of the 3,990 registered investment advisers, 1,369 or 34 percent have registered since the Dodd-Frank effective date of July 21, 2011. Thirty-two percent of all registered investment advisers report that they manage at least one private fund.
• Registered private fund advisers reported that they manage 30,617 private funds with combined assets of approximately $8 trillion. Hedge funds make up of approximately 53 percent of those assets under management and private equity funds represent about 24 percent of those private fund assets.
• A total of 1,950 exempt reporting advisers filed Form ADVs with the SEC by the March 30 deadline. Almost 41 percent of those exempt reporting advisers are foreign advisers (with the most being from the U.K.). The exempt reporting advisers reported that they manage 6,702 private funds with total assets of $1.5 trillion.
• It is expected that the number of SEC-registered investment advisers will be reduced by about 2,400 advisers when the mid-sized advisers complete the switch-over to state registration by the June 28, 2012 deadline. That would mean that about 10,200 advisers would be SEC-registered (i.e., a 25 percent decrease in the number of advisers), but there would be an approximate 12 percent increase in assets under management.

Another Update on Investment Adviser SRO
U.S. House Financial Services Committee Chairman Spencer Bachus recently announced that he is open to addressing concerns about the bill he co-authored and introduced in Congress to shift oversight of investment advisers from the SEC to one or more self-regulatory organizations (SROs). Some opposed to the legislation are concerned that, if enacted, FINRA may be the SRO chosen to fill that role.

Some in opposition to the SRO concept of regulating investment advisers believe that instead, registered advisers should be charged “user fees” to help fund an inspection program by the SEC. It is believed that Rep. Bachus would not be receptive to the user-fee concept. All agree that something has to be done, as currently the SEC does not have the manpower to effectively regulate the 12,000 advisers registered with the SEC. Rep. Bachus apparently believes that the only effective way to regulate registered investment advisers is to authorize a third party to conduct that registration. Rep. Bachus is receptive to discussing whether FINRA or another third party would be the most efficient way to go. As they say … stay tuned.

Enforcement

Non-Registered “Broker” Subject to SEC Enforcement Action
Often, the question arises as to whether an issuer of securities may pay a “finders fee” to a third party for referring investors to the issuer. The answer is generally “no,” as the SEC and state securities administrators generally take the position that under the current law, persons who receive a finder’s fee for soliciting investors in a securities offering are required to first become a registered broker-dealer with the SEC or a registered representative of a registered broker-dealer and licensed as a broker-dealer or agent of the issuer under the relevant state securities law(s), unless exempted from such state requirements. In many cases, the third party is not currently registered in any capacity with the SEC or any state and does not want to become registered or licensed to receive the referral fee. Generally, such a person would have to, among other things, take and pass one or more competency examinations prior to being granted registration and/or licensing.

The following SEC enforcement action illustrates the “broker-like” activities for which the SEC looks during an enforcement action against a non-registered third party who solicits investors for transaction-related compensation.

In the matter of Howard L. Blum (SEC Administrative Proceeding 3-14924), the SEC recently instituted cease-and-desist proceedings against Mr. Blum who, according to the SEC complaint, since 2007 engaged in the business of identifying, soliciting, and communicating with potential investors of securities for a particular issuer. In connection with such activities, Blum conducted his activities for the same issuer who was in the stock-collateralized loan business. Blum would solicit persons on behalf of the issuer to transfer ownership of the issuer’s stock held by such persons to the issuer in exchange for loans collateralized by such securities. Although Blum previously held certain securities licenses, he failed to maintain such licensing or registration at any time during the relevant period.

In addition to merely identifying and referring potential borrowers for the loans, Blum also conducted other broker-type activities such as acting as an intermediary in negotiations between the issuer and potential borrowers and was responsible for making sure that the loan transactions he brokered closed. During the relevant period reported on by the SEC within its complaint, Blum was paid by the issuer $904,880 as transaction-based compensation for brokering more than 25 stock-collateralized loans.

Based on the activities of Blum, the SEC alleged that he acted as a non-registered securities broker in violation of the broker registration requirements under the Securities Exchange Act of 1934. It is believed that due to Blum’s background as having previously taken securities broker examinations, the SEC believed he should have known that he was required to be registered in order to conduct such activities. In addition, when an investigation involves receiving transaction-based compensation, as Blum did, the SEC is almost always going to take the position that such person is acting as a securities broker.

Without admitting or denying the staff allegations, Blum agreed to the issuance of the SEC’s cease-and-desist order and prohibition for a period of 12 months from associating with any broker-dealer, investment adviser, municipal securities dealer, or transfer agent; serving or acting as an employee, officer, director, member of an advisory board, investment adviser, or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter; and participating in any offering of a penny stock. Blum was ordered to pay disgorgement of $904,880 with interest of $112,862, and a civil penalty of $50,000.

Interestingly, neither the issuer nor any of its principals were charged (at least not to this date) by the SEC with “aiding and abetting” a violation of a provision under the Securities Exchange Act of 1934. In some egregious cases, the SEC will name the issuer and/or its principals as a defendant if there is substantial evidence that such persons knew that the third-party non-registered broker was acting in violation of the Exchange Act. Although such persons may escape enforcement or civil action by the SEC, they may have liability under the relevant state securities laws (i.e., each of the states in which the non-registered and non-exempt third party conducted broker or agent activities) to those securities purchasers who were solicited by such non-registered third party. In addition, under many of the state securities laws, the issuer and/or its principals violate the law by engaging a non-registered, non-exempt person to conduct securities broker, dealer, or agent activities on their behalf in such states.

The lesson to be learned by this enforcement case is not to engage third parties to solicit investors without checking with securities counsel to determine whether it is lawful to do so and, if so, under what conditions.