piggy bank, chart, wallet, money, graph showing increaseThe SEC gave notice of intent to issue an order that would increase the minimum assets under management or net worth that a client must have before an investment adviser may charge performance-based fees. Section 205(a)(1) of the Advisers Act prohibits an adviser from being compensated by a client based on capital gains or capital appreciation of the client’s funds. Congress put this protection in place in 1940 to protect against advisers taking undue risks with client money in hopes of increasing the adviser’s fee. Performance-based fees were characterized as “heads I win, tails you lose.” These fees incentivize adviser’s to take risks to increase the adviser’s fee with little or nothing at stake for the adviser. 

Congress and the SEC later created exemptions to the prohibition. Under the exemptions, if a client has at least a minimum amount of assets under management or minimum net worth, the prohibition against performance-based fees no longer applies. The theory behind these exemptions is that client sophistication and financial experience increases with the amount of assets under management and net worth and that wealthy clients are able to bear the risks of performance-based fees. In many cases, merely because someone has assets under management of $500,000, $1,000,000, or some other arbitrary threshold, this has little or nothing to do with financial sophistication or risk tolerance.

The SEC now intends to increase the thresholds where the prohibitions against performance-based fees no longer apply to $1,100,000 in assets under management or $2,200,000 in net worth.

The SEC’s notice is available here.

check mark image with workersOregon Senator Jeff Merkley and U.S. Representative Bill Foster of Illinois introduced the Investor Choice Act earlier this month. The bill would prohibit broker dealers and investment advisors from forcing investors to agree to mandatory arbitration. The bill also prevents brokers dealers and investment advisors from forcing investors to waive the right to bring a class action lawsuit. The Senate’s version of the bill is available here

The North American Securities Administrators Association (NASAA) and Public Investors Advocate Bar Association (PIABA) endorsed the legislation. SEC Commission Chairman Gary Gensler said during his confirmation hearing that investors should be able to chose to go to court to resolve disputes.

Most agreements with individual investors in the financial services industry force customers into arbitration. Many investor advocates want investors to have the option of pursuing claims in court. Arbitration lacks the transparency of court and is sometimes cost prohibitive.

Image of nondescript charts and graphsThe SEC recently issued a public statement regarding certain leveraged and complex exchange traded products. The public statement begins by emphasizing that advisers and broker-dealers must actually understand the products they recommend to clients. The SEC wrote, “It is critically important for registered investment advisers and broker-dealers to implement robust and effective policies and procedures reasonably designed to prevent violations of the federal securities laws, which includes ensuring that their financial professionals understand the risks and purposes of the products they advise on and/or recommend to firm clients and customers. Moreover, firms must ensure that their financial professionals, including independent contractors acting on their behalf, actually follow in practice those firm policies and procedures.” The SEC explained that firms should not rely solely on individual advisers or registered representatives to be responsible for analyzing and understanding complex products. 

The SEC recommended that “firms should consider which products are complex, suitable only for sophisticated investors, not suitable for investors who plan to hold them for longer than one trading session or not suitable for longer-term investment, so that the firm can take appropriate steps concerning financial professional access, training, and/or compliance monitoring and review.” 

Relying on the Regulation Best Interest standard and an investment adviser’s fiduciary duty, the SEC said financial professionals who recommend a complex or risky product “should apply heightened scrutiny to understand the terms, features and risks of the product and whether such product fits within the client or customer’s risk tolerance and specific-trading objective, and whether it would require daily monitoring by the investor or the financial professional.”

generic graphThe Wall Street Journal reported that the SEC is not moving forward on a measure to require broker dealers and investment advisers to vet individual investors before permitting them to trade leveraged and inverse exchange-traded funds. These funds use debt to try to increase returns. But this leveraged approach to investing also increases the size of potential losses.

Many leveraged and inverse exchange-traded funds are complicated investments and difficult to understand. The Wall Street Journal reported that two companies that offer these investment products, Direxion Investments and ProShares considered the SEC’s proposed vetting requirement a threat to their business model. The Wall Street Journal also reported that between March and July, representatives and lobbyists for Direxion and ProShares met or had phone conferences with the SEC nine times.

SEC Commissioner Allison Herren Lee released a statement criticizing the SEC’s decision not to implement the protection for investors. The Commissioner wrote that she was “deeply disappointed in the failure to advance the proposed sales practice rules, which were designed to address the very real investor harms arising from unsuitable purchases and sales of leveraged and inverse ETFs.” The Commissioner further commented that many enforcement cases at the SEC and FINRA “have shown that even investment professionals often lack a basic understanding of these complex products.”

Investors have access to free electronic search tools through self-regulatory organizations, federal, and state regulators to research investment firms and professionals. This post describes several free tools that give access to information beyond what you can learn using Google and other search engines.

FINRA’s BrokerCheck is a good starting place to learn about registration and reported discipline. BrokerCheck allows you to search for an investment firm or professional by name or CRD number. BrokerCheck will tell you whether a firm is a broker or an individual is a registered representative regulated by FINRA. If regulated by FINRA, a BrokerCheck search will include information about reported disclosures, such as arbitrations or customer disputes, and provide information about registration. Click on the “Detailed Report” link—as the name of the link implies—for more detailed information, including summaries of any complaints. Also, keep in mind that through expungement, a broker can ask FINRA to remove customer complaints and arbitrations from records available through BrokerCheck. This means that an expunged complaint will not show up in your BrokerCheck search. Further, customer complaints are not always timely reported and may be missing from BrokerCheck.

FINRA also provides a free search tool for certain disciplinary actions since 2005. This search tool is available at https://www.finra.org/rules-guidance/oversight-enforcement/finra-disciplinary-actions-online.

If a firm is registered as an investment adviser or an individual is registered as an investment adviser representative, searching for the firm or individual using BrokerCheck will provide you with a link to the SEC’s Investment Adviser Public Disclosure website. For investment adviser representatives, the SEC’s Investment Adviser Public Disclosure search provides information similar to what FINRA makes available about brokers and registered representatives using BrokerCheck. For investment adviser firms, the SEC’s search tool gives access to the firm’s Form ADV, brochure, and Form CRS. These documents include information about an investment adviser’s business, including information about fees.

You should also check with the division in your state that regulates investment advisers. Some state regulators make available free information about investment advisers licensed to conduct business in the state. For example, the State of Oregon provides a free search tool that gives access to limited license information here: https://www4.cbs.state.or.us/ex/dfcs/dfcslic/adviser/.

On August 26, 2020, the SEC adopted amendments to the definition of “accredited investor.” Many private capital market offerings, including securities offerings conducted pursuant to Rule 506(b) and Regulation D under the Securities Act of 1933, along with certain offerings under state securities laws, are limited to accredited investors. These private offerings are sometimes higher risk than investments available in traditional markets. The amendments expand the definition to allow an individual investor who meets a financial sophistication test to qualify as an accredited investor. An individual may now qualify as an accredited investor based on professional knowledge, experience or certification. Previously, an individual had to meet income or net worth thresholds to be an accredited investor. The amendments also add to the entities that may now qualify to participate in private offerings. 

In explaining its rationale for expanding the definition, the SEC said it does not believe wealth should be the only means of establishing financial sophistication of an individual for purposes of the accredited investor definition. Underlying this change is the SEC’s theory that purportedly sophisticated investors are not in need of the same level of investor protections otherwise available under the securities laws and regulations. Advocates for investor rights have criticized the SEC for failing to address the fact that many individual investors who already qualify as accredited investors do not have the financial sophistication and access to information to understand and assess the risks of many private offerings. PIABA, for example, sent the SEC a comment letter in May, emphasizing the SEC’s primary objective of protecting investors and warning that the expanded definition undermines investor protection. PIABA’s comment letter is available here. The SEC’s Final Rule is available here.

Proposed Regulation 21F, that the U.S. Securities and Exchange Commission is currently reviewing, could impact the SEC whistleblower program. To receive a cash award under the program, a whistleblower must voluntarily disclose original information that leads to a successful enforcement in which the SEC obtains an order of monetary sanctions in excess of $1 million. The SEC sets the whistleblower’s award within a range of 10-30% of the sanctions collected. In setting an award, the SEC must comply with Section 21F of the Securities Exchange Act.

In June 2018, the SEC proposed new rules for the whistleblower program that would give the SEC more flexibility in determining awards. For relatively small awards, under $2 million, the new rule would allow the SEC to adjust the award upward. However, if the award is likely to exceed $30 million, the SEC could limit the award to 10% of the sanctions collected.

Under the current rules and Section 21F of the Securities Exchange Act, the SEC is to consider several factors in setting the award, including the degree of assistance and the significance of the information provided by the whistleblower. An emphasis under the proposed rule on the amount likely to be collected, instead of the factors in Section 21F, may discourage whistleblowers from coming forward, especially in very large cases.

To learn more about these and other proposed changes, visit the SEC website.

Beginning June 30, 2020, brokerage firms and their associated persons will have to comply with Regulation Best Interest (Reg BI), which sets a new standard of conduct when working with retail investors. The SEC adopted Reg BI, as the name suggests, to require firms and associated persons to work in the best interest of investor customers, not the firm’s own interest. Along with the overarching requirement that broker-dealers put the customer first, Reg BI includes four major obligations: 1) full disclosure of all material facts (such as of fees); 2) care, including exercise reasonable diligence, skill, as well as care, in making investment recommendations; 3) mitigation and control of conflicts of interest; and 4) compliance. Broker-dealers must implement policies and procedures to ensure these obligations are met. The Reg BI duties apply to investment recommendations, investment strategies, and account changes (such as rollovers).

Reg BI largely replaces FINRA’s suitability rule for many investors and is meant to be a heightened standard that firms must meet. The “care” obligation under Reg BI, however, aligns closely with the existing FINRA suitability rule and preserves suitability concepts. For institutional customers, in contrast to retail investors, the suitability rule is still in effect.

Reg BI also bars broker-dealers from using sales contests, sales quotas, bonuses, and other non-cash compensation based on a representative selling a specific investment or type of investment within a defined period of time.

On June, 3, 2020, the U.S. Securities and Exchange Commission (“SEC”) obtained a preliminary injunction against investment adviser Paul Horton Smith, Sr. and related entities. The SEC alleges Smith and his entities engaged in a Ponzi scheme targeting senior citizens.

The SEC’s complaint refers to three entities associated with Smith: Northstar Communications, LLC, eGate, LLC, and Planning Services, Inc. Through these entities, the complaint alleges that Smith targeted seniors, guaranteeing investors annual interest payments in so called “private annuity contracts.” Smith did not in fact invest the money as promised, the SEC explained, and instead used the money to pay investors in a Ponzi-like fashion. The SEC also alleges that Smith held himself out to be a trusted fiduciary.

The case is Securities and Exchange Commission v. Paul Horton Smith, Sr., et al., Central District of California, No. ED CV 20-1056 PA (SHKx).

The U.S. Securities and Exchange Commission (“SEC”) filed a complaint for fraud against Applied Bioscience Corp. in May 2020. The SEC alleges that Applied Biosciences Corp. sought to exploit the COVID-19 pandemic for profit. In March 2020, the company changed its focus from cannabinoid-based products to pandemic-related products to “help battle the spread of COVID-19.” In late March, the company issued a press release outlining their sales of home test kits to the general public for COVID-19. The SEC determined that no shipments occurred and that the press release was misleading as the company did not disclose the FDA had not approved or authorized the sale of any COVID-19 at home test kits.

The SEC’s complaint charges the company with fraud for violating the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.

The case is Securities and Exchange Commission v. Applied Biosciences Corp., S.D.N.Y., Case No. 20 Civ. 3729.

In September, the SEC alleged that Elon Musk falsely claimed in a series of tweets on August 7, 2018 that he had lined up funding and support to take Tesla private at $420 per share, with backing from Saudi Arabia’s public investment fund. The announcement boosted Tesla’s stock price about 6 percent to close at $379.57 a share that day, although the price has since fallen 28.4 percent, to $271.78, as of Wednesday evening. Continue reading “Tesla Settles with SEC – Other Suits Remain”

According to an article in the publication called The Hill, President Trump’s appointee to the SEC suggested that the SEC may consider removing a ban that has been in place for years that has prohibited securities issuers from putting class action bans in their disclosures relating to IPO’s.

Continue reading “SEC considering allowing class action bans in IPO’s”

A motion for preliminary approval of a class action settlement was filed in California federal court on December 19, 2017 by investors in Marvell Technology. Under the deal, Marvell will pay pay $72.5 million to end an investor class action alleging the company’s stock dropped 16 percent after inflated revenue projections proved false.

Continue reading “Marvell Technology settles securities class action for $72.5 million”

A brief remark from SEC Commissioner Michael Piwowar during a July 17, 2017, Q&A suggests that he believes the U.S. Securities and Exchange Commission might soon allow companies to introduce mandatory arbitration clauses into their corporate charters.

Continue reading “SEC Commissioner suggests that SEC will allow corporations to put mandatory arbitration clauses into their charters to avoid shareholder securities fraud class actions”